Full Course notes ICAEW Certificate Level Management Information For exams in 2026

Full Course notes ICAEW Certificate Level Management Information For exams in 2026

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ii Intro ductio n

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Management Infor mation

Management Infor mation

Intro ductio n

Contents Page 1 The ACA qualification and Management Information (MI) 2 Accessing the First Intuition online content

v vi

1: Fundamentals of costing

1

1 What is cost accounting?

2 Basic cost accounting concepts 3 Cost classification 4 Cost classification for planning and decision-making 5 Cost classification for control 6 Ethics and professional scepticism 7 Sustainability, governance and corporate responsibility

2 3 5 7 11 12 13

2: Calculating unit cost (part 1)

15

1 Calculating the production cost of a cost unit 2 Identifying direct & Indirect costs 3 Inventory valuation

16 16 19

3: Calculating unit cost (part 2)

25

1 Absorption Costing 2 Costing methods

26 35

4: Marginal costing and absorption costing

37

1 Absorption costing 2 Marginal cost and marginal costing 3 Marginal costing and absorption costing compared

38 40 43

5: Pricing calculations

49

1 Pricing approaches 2 Cost-plus pricing 3 Mark-ups and margins 4 Transfer pricing

50 50 53 55

6: Budgeting

63

1 Why do organisations prepare budgets?

2 A framework for budgeting 3 Steps in the preparation of a budget 4 The Master Budget 5 Preparing forecasts 6 Alternate approaches to budgeting 7 Beyond Budgeting 8 Big data, data analytics and data mining 9 Machine Learning 10 Data bias and professional scepticism

64 64 65 70 71 77 79 79 81 82

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7: Working capital

85

1 What is ‘working capital‘?

2 Balancing liquidity and profitability 3 Assessing the liquidity position via ratios 4 The Cash Operating Cycle 5 Managing inventory 6 Managing trade payables 7 Managing trade receivables 8 Treasury management 9 Cash budgets

86 86 86 87 91 92 93 95 95

8: Performance management

99

1 Performance evaluation 2 Responsibility centres 3 Performance measures for investment centres 4 The balanced scorecard 5 Budgetary control 6 Organisational efficiencies relative to performance management 7 Sustainability and ESG reporting

100 101 103 105 106 108 109

9: Standard costing and variance analysis

113

1 Standard costing and standard costs 2 Variance analysis 3 Sales variances 4 Material variances 5 Labour variances 6 Overhead variances 7 Operating statements 8 Interpreting variances

114 115 116 118 120 122 124 125

10: Breakeven analysis and limiting factor analysis

129

1 Breakeven analysis and contribution 2 Breakeven charts 3 Limiting Factor Analysis

130 134 135

11: Investment appraisal techniques

143

1 Making investment appraisal decisions 2 The payback period 3 The Accounting Rate of Return (ARR) 4 Net Present Value (NPV) 5 The internal rate of return (IRR) 6 Environmental costs

144 144 146 147 156 161

12: Answers to interactive questions

163

Management Infor mation

Intro ductio n

1 The ACA qualification and Management Information (MI) There are 15 modules that can be taken in any order with the exception of the Case Study which you must be attempt last. You must pass every exam (or receive credit) – there are no options. Once qualified, all ICAEW Chartered Accountants have a consistent level of knowledge, skills and experience.

Certificate Level The six certificate level modules introduce the fundamentals of accountancy, finance and business.

Each has a 1.5-hour computer-based assessment which can be sat at any time. You may be eligible for credit for some modules if you studied accounting, finance, law or business at degree level or through another professional qualification.

The six certificate modules are also available as a stand-alone certificate, the ICAEW Certificate in Finance, Accounting and Business (ICAEW CFAB). On successful completion, you can use CFAB as a stepping stone to study to the ACA.

Specification gird and Weightings for MI MI aims to enable candidates to prepare essential financial information for the management of a business.

The grid below shows the weightings of subjects within POT and should guide your relative study time.

In each assessment, the marks available equate to the weightings.

Costing, pricing and ethics Budgeting and forecasting Performance management and management information operations Management decision making

Weighting (%) 25 25 25 25 100

Method of assessment MI is a 1.5-hour exam There is one long-form question (covering a single syllabus area, either: absorption vs marginal costing; pricing; budgeting; variance analysis; or breakeven, limiting factors and investment appraisal) worth 20 marks and 32 short-form questions in total (each short-form question is worth 2.5 marks). You have 90 minutes to answer the exam.

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Intro ductio n

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There will be a mix of question types in the assessment, eg: 🞂

Multiple choice (choose one answer)

🞂

Multiple response (choose more than one answer or choose one answer for each part of the question)

The pass mark is 55%

2 Accessing the First Intuition online content You have access to FI’s online course which includes recorded lectures, question debriefs, your mock exams and step by step guidance to help you succeed in the exam.

A link to FI Learn should have been sent to you by your centre, giving full access to the online content.

When you access the link for the first time you will be prompted to create a password. Please contact your centre if you have not received the link to access the course.

If you are an online learner, it is important that you log in and listen to the introductory videos in the getting started pod of the course. These videos explain the MI exam and the resources you have to help you pass.

Good Luck with your studies!

The FI Team

1

1 Fundamentals of costing

Topic List 1

What is cost accounting?

2

Basic cost accounting concepts

3

Cost classification

4

Cost classification for planning and decision-making

5

Cost classification for control

6

Ethics and professional scepticism

7

Sustainability, governance and corporate responsibility

Learning objectives 🞂

Understand the concept of cost, and how cost information can be used for different purposes

🞂

Understand different cost classifications and the meaning and use of fixed, variable, direct and indirect costs

🞂

Classify costs as fixed, variable and semi-variable (or semi-fixed) and recognise where each can be used in decision-making

🞂

Identify and explain ethical issues relating to the preparation, presentation and interpretation of financial information for the management of a business.

🞂

Understand the concept of sustainability

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1 What is cost accounting?

1.1 The cost accountant Cost accounting focuses on finding the cost of activities undertaken by a business during a specified period and quantifying the revenue and profits generated by those activities.

For example, a cost accountant would be expected to be able to determine the following: 🞂

The cost of goods produced, or services provided during a specified period.

🞂

The costs incurred from operating a department during a specified period.

🞂

Revenues earned during a specified period.

Management can then use this information to: 🞂

Assess the profitability of a product, a service, a department, or the whole organisation.

🞂

Determine selling prices for goods and services.

🞂

Valuing inventory and determine the cost of materials or goods used or sold in a period.

Cost accountants need to look forward as well as backwards to help provide forecasts and estimates, such as: 🞂

What are the future costs of goods and services likely to be?

🞂

What information does management need in order to make sensible decisions about future profits and costs?

🞂

What financial resources will be needed to fund future growth or activities?

1.2 Cost accounting and management accounting In today’s environment the role of cost accounting in the provision of management information is almost indistinguishable from that of management accounting.

Management accountants are tasked with the provision of information to assist management with planning, control and decision making (see below).

1.3 Cost accounting systems The managers of a business have responsibility for planning and controlling the resources used (e.g. materials, people, money). As a result, the cost accounting system should provide suitably detailed and accurate information.

In summary, cost accounting is concerned with providing information to assist the following. 🞂

Establishing inventory valuations, profits or losses and balance sheet values.

🞂

Planning (for example the provision of forecast costs at different activity levels)

🞂

Control (such as the provision of actual and standard costs for comparison purposes)

🞂

Decision making (for example, the provision of information about actual unit costs for the period just ended for pricing decisions).

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1 : Fun dame ntals of costing

1.4 Financial accounting versus cost accounting The financial accounting and cost accounting systems in a business both record the same basic data for income and expenditure, but each set of records may analyse the data in a different way. This is because each system has a different purpose. 🞂

Financial accounts are usually prepared for stakeholders external to an organisation, e.g. shareholders, banks, customers, suppliers and HMRC.

🞂

Management accounts are usually prepared for internal managers of an organisation.

The data used to prepare financial accounts and management accounts are the same. The differences between the financial accounts and the management accounts arise because the data is usually analysed differently.

Financial Accounts

Management Accounts

Purpose

Show the performance, financial position and cashflows over a defined period.

Also include performance, position and cashflow information, but presented in more detail to aid management planning/control/decision making.

Legal requirement

A legal requirement for UK companies.

No legal requirement.

Format

Format determined by law and Financial Reporting Standards.

No prescribed format.

Coverage

Financial information is historical and is shown at a high level (e.g. for the whole business).

Information shown can be historical or futurelooking and may be shown at a higher level of detail (e.g. at a department or product level) to aid decision making and include budgets/forecasts.

Information type

Mostly monetary information.

Monetary and non-monetary information (e.g. sales volumes, quantity of materials used, hours worked).

Time period

Typically 1 year.

Can cover any period (weekly/monthly/quarterly/annual).

2 Basic cost accounting concepts Throughout the remainder of this chapter and the following two chapters we will consider several key concepts and terms relating to cost accounting.

As there are several stages to cost accounting, it will be helpful to refer back to a consistent real-world example to provide context for the theories and concepts we will encounter. 🞂

Consider a company producing high quality baked goods (BakeCo): –

BakeCo produces several types of baked goods on a large scale.

–

BakeCo’s products include bread, cakes, pies and tarts.

–

All of BakeCo’s products are produced on one factory with multiple departments (Mixing, Baking, Finishing, Stores and Canteen).

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2.1 Functions and departments Organisations are typically split into different functions, which may be categorised as follows: 🞂

Production functions (functions concerned with the production of goods / provision of services to customers)

🞂

Non-production functions (such as administration, distribution and marketing)

Each of these functions will comprise several different departments – e.g. BakeCo’s production function has the following departments: Function

Department

Description

Production

Mixing

Mixes the ingredients together and prepares them for baking.

Baking

Bakes the prepared mixed ingredients.

Finishing

Applies icing / decoration / finishing touches to the baked goods.

Stores

Stores the raw ingredients used in the products.

Canteen

Where the production staff each lunch.

The departments in the production function can then be split into: 🞂

Production departments (those departments directly involved in the production of the goods – e.g. Mixing, Baking and Finishing).

🞂

Service departments (the departments not directly involved in the production of the goods, but which support the production departments – e.g. Stores and Canteen).

2.2 Cost objects A cost object is anything for which we are trying to ascertain the cost, including (but not limited to): 🞂

A unit of our product or service (e.g. one cake for BakeCo)

🞂

A department or function for a certain time period (e.g. the Baking department for the prior week).

🞂

A project (e.g. the installation of a new computer system).

2.3 Cost units The cost object that is usually most significant for organisations is a cost unit. This is typically one unit of the product or service that a business sells / provides to customers.

For example: Business

Cost unit examples

BakeCo

One loaf of bread / cake / pie / tart

Car manufacturer

One car

Steelworks

One tonne of steel produced

Hospital

Patient/day* or Operation or Out-patient visit

Freight organisation

Tonne/kilometres

Passenger transport organisation

Passenger/kilometre*

Accounting firm

Audit performed or Chargeable hour

Restaurant

Meal served

Much of the focus of chapters 1-3 will be calculating the cost of producing one cost unit.

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1 : Fun dame ntals of costing

Composite cost units Notice that some of the cost units in the above table are made up of two parts, for example the patient/day cost unit for the hospital. 🞂

These two-part cost units are known as composite cost units and they are used most often in service organisations. can provide a more useful measure for the organisation.

🞂

i.e. the cost per patient will vary depending on the length of the patient’s stay, therefore monitoring costs on a patient/day basis would be most appropriate.

INTERACTIVE QUESTION 1: COST UNITS

[DIFFICULTY LEVEL: EASY]

Identify which of the following cost objects would be suitable cost units for a hotel.

Cost object

Suitable cost unit?

Bar

Yes / No

Restaurant

Yes / No

Room/night

Yes / No

Meal served

Yes / No

Conference delegate

Yes / No

Fitness suite

Yes / No

Conference room/day

Yes / No

3 Cost classification In chapters 1-3 we will attempt to calculate the production cost of one cost unit (e.g. one cake for BakeCo) in order to calculate: 🞂

The value of any inventory of finished goods held at a point in time.

🞂

The cost of goods sold during a period of time (to enable profit calculations).

In order to achieve this, we must first break any costs incurred down into different cost categories:

3.1 Cost elements For the purposes of inventory valuation and profit measurement, the cost of one unit is typically made up of the following three elements of cost: 🞂

Materials

🞂

Labour

🞂

Other expenses (such as rent and rates, interest charges and so on)

Cost elements can be classified as direct costs or indirect costs as far as cost units are concerned.

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3.2 Direct cost and prime cost A direct cost is a cost that can be traced in full to the cost unit.

There are three types of direct cost: Direct cost type

Description

BakeCo example (for one cake)

Direct materials

The raw materials used in making the product.

Eggs, flour, sugar, butter, packaging.

Direct labour

The cost of time spent by the production workforce to make the product.

The wages paid to the staff who mix the ingredients and bake and finish the cakes.

Direct expenses

Additional expenses incurred as a direct result of making a unit of the product.

The cost of hiring a special machine to help produce a special order for customer.

🞂

Identification of direct costs is important in costing, as it should be easy to quantify these costs for one unit of our product without having to perform complex calculations.

Another term used to describe the total direct cost is prime cost. 🞂

Prime cost = total direct cost = direct material cost + direct labour cost + direct expenses.

🞂

For example, one BakeCo cake would have the following direct costs:

Direct materials: Eggs Sugar Flour Butter Direct labour: Mixing Baking Finishing Prime cost

Quantity 0.2 kg 0.225 kg 0.225 kg 0.225 kg

Price / Rate £3.00/kg £2.00/kg £1.20/kg £4.40/kg

Cost per unit £0.60 £0.45 £0.27 £0.99

0.05 hours 0.05 hours 0.10 hours

£10/hour £10/hour £10/hour

£0.50 £0.50 £1.00 £4.31

3.3 Indirect cost However, many costs incurred by an organisation cannot be directly traced to individual units of the products produced. These are called indirect costs (or overheads).

Indirect costs are split into two categories:

Indirect production costs (production overheads) These are indirect costs incurred during the production of the product. In the case of BakeCo, they would include indirect costs incurred in their factory, such as: Cost type

Description

BakeCo examples

Indirect materials costs

Materials which can’t be traced to individual units of product, A lightbulb used in the or which are used in negligible amounts across multiple units. factory.

Indirect labour

Any labour costs not traceable to individual units of product, such as supervisor salaries or bonuses paid at the end of a period.

The salary of the supervisor in the mixing department.

Indirect expenses

Other production costs not directly traceable to individual units of product, including factory rent and rates, factory utilities costs and depreciation, maintenance and insurance of production machinery.

The cost of the electricity used in the factory.

Management Infor mation

1 : Fun dame ntals of costing

🞂

These production overheads will typically need to be included when calculating the production cost of one unit of our product (e.g. the production cost of one cake for BakeCo).

🞂

As more production becomes automated, an increasing proportion of a business’ production costs will become indirect.

Non-production overheads Any costs not related to the production of our products are called ‘non-production overheads’. 🞂

These costs will not be included when calculating the production cost of one unit of product (for the purposes of inventory valuation and cost of sales calculations).

🞂

However, they will still need to be forecast, monitored, controlled and included in profit calculations for the organisation.

🞂

Typical examples of non-production overheads include:

Cost type

Description

BakeCo examples

Administration overheads

Non-production administration costs such as salaries of office workers and rent, rates, insurance and utilities costs of the general offices.

The salary of BakeCo’s financial controller.

Selling and distribution overheads

Any costs related to the selling and distributing our products, such as marketing team salaries, costs of delivering goods to customers, sales commission and advertising costs.

The salary of BakeCo’s head of marketing.

4 Cost classification for planning and decision-making 4.1 Cost behaviour patterns As we will see in chapter 6, in order to forecast the costs we will incur in a future period (e.g. in order to produce a budget), we must understand how our costs behave relative to our activity levels.

Crucially, we need to understand how our costs vary as our output increases (i.e. does a certain cost increase as BakeCo produces a greater quantity of bread, cakes, pies and tarts?).

We will see that most costs can either be described as fixed, variable, semi-variable or stepped.

4.2 Fixed cost This is a cost that, within a relevant range of activity levels, is unaffected by increases or decreases in the level of activity (units of product produced) such that the total cost incurred is constant.

E.g. for BakeCo the factory rent paid is unaffected by the number of cakes they produce in the period. 🞂

The behaviour of the total cost is shown in the left-hand graph below.

🞂

Examples include factory rent and supervisor salaries.

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Total cost

Cost per unit

Management Infor mation

Volume of output (units)

🞂

Volume of output (units)

Hence, as we produce more units of our product, the cost per unit (total cost / # units produced) will decrease (per the right-hand graph above).

4.3 Variable cost This is a cost that increases or decreases as the level of activity increases or decreases, such that each additional unit of product produced incurs a constant additional cost.

E.g. for BakeCo each additional cake produced will lead to an additional £1 spent on eggs.

The behaviour of the total cost is shown in the left-hand graph below.

🞂

Examples include direct materials and direct labour.

Total cost

Cost per unit

🞂

Volume of output (units)

🞂

Volume of output (units)

Hence, even as we produce more units of our product, the cost per unit (total cost / # units produced) will remain constant (per the right-hand graph above).

4.4 Semi-variable cost (or semi-fixed or mixed cost) These costs have both a fixed and variable element. Hence, a minimum fixed cost will always be incurred (regardless of production levels), but the total cost will increase as the level of production increases.

E.g. BakeCo may be charged a fixed standing charge and a variable usage charge (per kilowatt hour) by their electricity supplier, leading to a semi-variable electricity cost. 🞂

The behaviour of the total cost is therefore a hybrid of the previous fixed and variable cost graphs (see the left-hand graph below).

Management Infor mation

1 : Fun dame ntals of costing

Examples include electricity bills and the cost of members of the sales team (who may get a fixed basic salary and a unit commission for each additional unit of product sold).

🞂

As we produce more units of product, the cost per unit (total cost / # units produced) will reduce (like a fixed cost), but will never reduce below our variable cost per unit (per the righthand graph below).

Total cost

Cost per unit

🞂

Variable part

Fixed cost

Fixed part Var. cost / unit Volume of output (units)

Volume of output (units)

4.5 The relevant range and stepped costs The relevant range is the range of activity levels within which assumed cost behaviour patterns occur.

A fixed cost is only fixed for levels of activity within the relevant range, after which it could “step up”

🞂

For example, as our production volume increases we will eventually need to rent additional factory space, leading to an increased rental cost.

🞂

Hence, most fixed costs are actually stepped costs in the long-term as a business grows (e.g. rent and salary costs) – see the example graph below: Total cost

🞂

Volume of output (units)

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INTERACTIVE QUESTION 2: ACTIVITY LEVELS

[DIFFICULTY LEVEL: INTERMEDIATE]

Delete as appropriate in the following sentence: In general, as activity levels rise within a relevant range (a)

the variable cost per unit will rise/fall/stay the same

(b)

the fixed cost per unit will rise/fall/stay the same

(c)

the total cost per unit will rise/fall/stay the same.

INTERACTIVE QUESTION 3: COST BEHAVIOUR GRAPHS

[DIFFICULTY LEVEL: INTERMEDIATE]

Match the sketches (1) to (4) below to the listed items of expense. In each case the vertical axis relates to total cost and the horizontal axis relates to the activity level. Each graph may be used more than once. Write the graph number in the space provided. (a)

Electricity bill: a standing charge for each period plus a charge for each unit of electricity consumed.

(b)

Supervisory labour, which is paid on a monthly salary.

(c)

Sales commission, which amounts to 2% of sales revenue.

(d)

Machine rental cost of a single item of equipment. The rental agreement is that £10 should be paid for every machine hour worked each month, subject to a maximum monthly charge of £480.

(e)

Photocopier rental costs. The rental agreement is that £80 is paid each month, plus £0.01 per photocopy taken.

1

2

3

4

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Cost

1 : Fun dame ntals of costing

Cost type

Graph number

(a) (b) (c) (d) (e)

5 Cost classification for control 5.1 Responsibility accounting When considering the control of costs in an organisation (as we will in chapter 9 when we study variance analysis), it is important to consider which individuals in the organisation are responsible for individual costs.

For instance, the marketing manager would have responsibility for our advertising expenditure for the period. 🞂

A system that splits revenues and costs between different responsible staff members (usually managers) is known as a responsibility accounting system.

🞂

A department or function whose performance is the direct responsibility of a specific manager is known as a responsibility centre.

🞂

In order for responsibility accounting to work well, managers should only be held responsible for revenues and costs that they can control or influence.

5.2 Controllable and uncontrollable costs Cost type

Definition

Notes

Controllable cost

A cost that can be influenced by management decisions and actions

Most variable costs within a department are thought to be controllable in the short-term (as managers can influence the efficiency of their team’s use of such resources).

Uncontrollable cost

A cost that cannot be affected by management within a given time span

Even though a cost may not be controllable by one manager (e.g. the Mixing manager cannot control the price paid for ingredients used), it may be controlled by another more senior manager / manager in another department (e.g. procurement).

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6 Ethics and professional scepticism 6.1 Ethics Fundamental ethical principles The fundamental ethical principles you have studied in previous certificate level papers are equally applicable in Management Information and the work of management / cost accountants: Principle

Definition

Integrity

Being straightforward and honest in all professional and business relationships.

Objectivity

Not allowing bias, conflict of interest or the undue influence of others to override professional or business judgements.

Professional competence and due care

A continuing duty to: 🞂 Maintain professional knowledge and skill at the level required 🞂 Act diligently in accordance with applicable technical and professional standards

Confidentiality

A duty to: 🞂 Respect the confidentiality of information acquired as a result of professional and business relationships; 🞂 Refrain from disclosing such information without proper and specific authority unless there is a legal or professional right or duty to disclose; and 🞂 Refrain from using such information for their personal advantage or the advantage of third parties.

Professional behaviour

Complying with relevant laws and regulations and avoid any action that discredits the profession.

Threats to the fundamental principles During the course of their work, whether in practice or industry, accountants should be alert to threats that they face which may impact on their ability to carry out their duties in line with the ICAEW fundamental principles.

Threat

Definition / example

Self Interest

A threat to objectivity / professional behaviour / integrity due to potential personal gain

Self-Review

The threat to objectivity of the re-evaluation of previous work by the person who performed the original work

Intimidation

The threat to objectivity of intimidation by or threats from a client

6.2 Professional scepticism There may be deliberate or accidental mistakes within information and professional scepticism means being aware of this and accepting that verification may be necessary.

This is particularly important for audit but is also important for management information. For example, if a colleague provides you with data and asks you to write a report about that data, you should want to verify that the data is correct, particularly if it came from the internet.

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7 Sustainability, governance and corporate responsibility When running a business it is vital to consider sustainability issues in order to safeguard the long-term performance of the business.

7.1 Key definitions Term

Definition

Sustainability

The ability to meet the needs of current generations without compromising the needs of future generations.

Sustainable development

The process by which we achieve sustainability.

Corporate responsibility

The actions, activities and obligations of business in achieving sustainability.

Governance

The way in which organisations are managed and controlled by senior officers.

Sustainability is often considered under three key headings: Issue

Examples

Social

Health and safety, workers’ rights (in the business and its supply chain), pay and benefits, diversity and equal opportunities, impacts of product use, responsible marketing, data protection and privacy, community investment, and bribery/corruption.

Environmental

Climate change, pollution, emissions levels, waste, use of natural resources, impacts of product use, compliance with environmental legislation, air quality.

Economic

Economic stability and growth, job provision, local economic development, healthy competition, compliance with governance structures, transparency, long-term viability of businesses, investment in innovation/new product development.

🞂

Economic sustainability is dependent on both a healthy environment and a healthy society, hence all three types of sustainability are linked and must be considered by boards of directors in order to achieve long-term sustainable success for their business.

7.2 Sustainability vs. ESG Term

Definition

ESG

ESG stands for Environmental, Social and Governance and focuses on a narrower corporate view of sustainability and the impact of sustainability issues on businesses (and their impact on people and the environment).

When a business considers ESG, it must determine: 🞂

Impacts: how its decisions positively and negatively affect environmental, societal and governance issues.

🞂

Dependencies: how environmental, societal and governance issues can affect the business.

🞂

Double materiality: how sustainability issues can materially affect the business (financial materiality), but also how the business can materially impact on people and the environment (impact materiality).

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7.3 Global initiatives to promote sustainable development Governments, business and organisations have taken various steps to enable and encourage businesses to act in a sustainable way, including: 🞂

Taxes and subsidies

🞂

Voluntary codes

🞂

Stakeholder engagement

7.4 Focus for the MI exam You will primarily encounter sustainability issues in the following Chapters in MI: 🞂

Chapter 7 (good, fair payment practices)

🞂

Chapter 8 (tracking sustainability performance against targets)

🞂

Chapter 11 (environmental costing)

Learners are also expected to have an appreciation of the operational risks for businesses arising from climate and environmental change and the reputational risks that could arise from ignoring their ESG responsibilities.

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Do you know the differences between financial and management accounts?

Can you explain the terms cost object and cost unit?

What is the meaning of prime cost?

What are indirect costs?

What are indirect costs? Can you draw the graphs for the various types of cost behaviour?

What are the fundamental principles in the ICAEW ethical guidance?

What is ESG?

Yes/No

15

2 Calculating unit cost (part 1)

Topic List 1

Calculating the production cost of a cost unit

2

Identifying direct and indirect costs for cost units

3

Inventory valuation

Learning objectives 🞂

Classify costs as direct or indirect as regards costs units

🞂

Calculate direct material and direct labour costs from information provided

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Management Infor mation

2 : Calculating unit co st ( part 1 )

1 Calculating the production cost of a cost unit Our primary goal in the next two chapters is to calculate the production cost of one unit of our product (one cost unit), to be shown in a cost card.

As for chapter 1, we will continue to consider BakeCo, whose cost card for a sponge cake would look like the below: Direct materials: Eggs Sugar Flour Butter Direct labour: Mixing Baking Finishing Prime cost Variable overheads Fixed overheads Full production cost

Quantity

Price / Rate

Cost per unit

0.2 kg 0.225 kg 0.225 kg 0.225 kg

£3.00/kg £2.00/kg £1.20/kg £4.40/kg

£0.60 £0.45 £0.27 £0.99

0.05 hours 0.05 hours 0.10 hours

£10/hour £10/hour £10/hour

0.2 hours 0.2 hours

£0.80/hour £0.60/hour

£0.50 £0.50 £1.00 £4.31 £0.16 £0.12 £4.59

🞂

The above cost card is our end goal, we now need to consider how to calculate each of the individual components.

🞂

In this chapter, we will consider: (i)

How to split costs between direct and indirect

(ii)

How to value the materials used in our product

2 Identifying direct & Indirect costs 2.1 Reminder of direct vs. indirect costs We saw in chapter 1 that costs can be classified as direct (directly traceable to a cost unit), or indirect (not directly traceable to a cost unit):

Direct costs Direct cost type

Description

BakeCo example (for one cake)

Direct materials

The raw materials used in making the product.

Eggs, flour, sugar, butter, packaging.

Direct labour

The cost of time spent by the production workforce to make the product.

The wages paid to the staff who mix the ingredients and bake and finish the cakes.

Direct expenses

Additional expenses incurred as a direct result of making a unit of the product.

The cost of hiring a special machine to help produce a special order for customer.

Management Infor mation

2 : Calcula tin g unit co st ( part 1 )

Indirect production costs Cost type

Description

BakeCo examples

Indirect materials costs

Materials which can’t be traced to individual units of product, or which are used in negligible amounts across multiple units.

A lightbulb used in the factory.

Indirect labour

Any labour costs not traceable to individual units of product, such as supervisor salaries or bonuses paid at the end of a period.

The salary of the supervisor in the mixing department.

Indirect expenses

Other production costs not directly traceable to individual units of product, including factory rent and rates, factory utilities costs and depreciation, maintenance and insurance of production machinery.

The cost of the electricity used in the factory.

Non-production overheads Cost type

Description

BakeCo examples

Administration overheads

Non-production administration costs such as salaries of office workers and rent, rates, insurance and utilities costs of the general offices.

The salary of BakeCo’s financial controller.

Selling and distribution overheads

Any costs related to the selling and distributing our products, such as marketing team salaries, costs of delivering goods to customers, sales commission and advertising costs.

The salary of BakeCo’s head of marketing.

2.2 Special situations – staff pay: Certain staff costs can have different treatments depending on the situation (and the type of cost unit): 🞂

The basic pay of direct production workers (those who manufacture the product / provide the service) will always be considered as direct.

🞂

If staff work overtime and are paid an overtime premium, the overtime premium paid will be considered to be indirect if worked on general production of our product: –

E.g. If a member of the BakeCo mixing team works overtime on general cake production one week (due to unexpected demand) and is paid a £10/hour basic rate and a 20% overtime premium of £2/hour, the £10 basic rate will be considered to be direct for all hours worked, but the £2 premium paid for overtime hours worked will be considered indirect.

🞂

However, if the cost-unit is a ‘job’ (a bespoke service offered to a specific customer), the overtime premium will be considered to be direct if worked at the request of the customer (e.g. in order for the job to be completed early), as it is directly traceable to that cost unit (the job).

🞂

Bonuses paid to staff will also usually be considered to be indirect (as they are not directly traceable to individual cost units).

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Management Infor mation

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WORKED EXAMPLE: DIRECT AND INDIRECT COSTS For example, a garage carries out a repair job on a customer’s car (hence the cost unit here is the job). 🞂

The direct material cost of the job will include the replacement parts used.

🞂

The direct labour cost will be wages paid to the mechanics who carried out the work. The labour is treated as a direct cost in this case, even if the mechanics are paid a fixed amount each period. This is because it is possible to measure exactly how long each person worked on the repair, and their hourly rate of pay.

🞂

The indirect costs of the repair job will include a share of the overhead costs incurred in the garage, such as the rent, the buildings insurance, the depreciation of the garage equipment and so on. These costs cannot be traced to any single job worked on during the period.

🞂

If there has been overtime worked, it will be important to understand the reason why: –

If the overtime is worked due to a generally heavy workload then it will be classed as indirect.

–

If, however a particular car repair has meant that overtime is worked, for example where the owner of the car has requested a quick repair, then it can be traced to that particular unit and will be classed as a direct cost.

Try this interactive question to ensure you have understood the principle of how to distinguish a direct cost from an indirect cost.

INTERACTIVE QUESTION 1: DIRECT COST OR INDIRECT COST?

[DIFFICULTY LEVEL: INTERMEDIATE]

Indicate whether each of the following costs would be classified as a direct cost or an indirect cost of a particular car repair in a garage. The repair was worked on in overtime hours due to an unusually large number of repairs being booked into the garage that day.

Cost incurred The salary of the garage's accountant The cost of heating the garage A can of engine oil used in the repair A smear of grease used in the repair An overtime premium paid to the mechanic carrying out the repair An idle time payment made to the mechanic while waiting for a delivery of parts for a number of jobs The wages of the supervisor overseeing the mechanic carrying out the repair

Direct or indirect?

Management Infor mation

2 : Calcula tin g unit co st ( part 1 )

3 Inventory valuation 3.1 Charging units of inventory to cost of production or cost of sales Consider an organisation (such as BakeCo) which manufactures a physical product (e.g. cakes). Such an organisation will use several different types of materials when producing their end product.

In the case of BakeCo, they will use the following materials to produce a sponge cake: eggs, sugar, flour and butter.

(1)

When these materials are purchased, they will be recorded at their purchase price (cost) in the raw materials inventory account of BakeCo.

(2)

When they are then used to produce a cake, the cost of the materials used in (‘issued to’) production will be credited to the raw materials inventory account and then debited to a finished goods inventory account.

(3)

Once the goods are sold, the production cost of those goods will be credited to the finished goods inventory account will now be recorded as cost of sales in the income statement for the period.

Note: if the organisation is a retailer (who buys goods and then sells them on without doing further work on them), the issuances in step 2 will actually be sales, so the double entry will be to credit inventory and debit cost of sales.

The problem with the above steps is that the price of the materials (e.g. sugar) will change over time: 🞂

It is clear that in step 1 we must record the purchases at the purchase price paid.

🞂

However, in step 2 (when we record the cost of the materials used in production), we might be using materials purchased over several periods, hence which purchase price should be used?

🞂

We will see that there are three different approaches to valuing the materials issued to production: –

First In First Out (FIFO)

–

Last In First Out (LIFO)

–

Average cost (AVCO)

In the following sections we will consider each of the above pricing methods, using the following transactions to illustrate the principles in each case.

TRANSACTIONS DURING MAY 20X6 Date

Transaction

Units

Unit Cost (£)

Total cost (£)

01 May

Opening Balance

100

2.00

200

03 May

Receipt

400

2.10

840

04 May

Issue

(200)

09 May

Receipt

300

2.12

636

11 May

Issue

(400)

18 May

Receipt

100

2.40

240

20 May

Issue

(100)

31 May

Closing Balance

200

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Management Infor mation

2 : Calculating unit co st ( part 1 )

3.2 FIFO (first in, first out) FIFO assumes that materials are issued out of inventory in the order in which they were delivered into inventory → hence, issues are valued at the cost of the earliest delivery remaining in inventory.

WORKED EXAMPLE: FIFO Using FIFO, the cost of issues and the closing inventory value of the transactions in section 2.4 would be as follows.

Quantity

Unit value (£)

Total value (£)

Balance (units)

Balance (£)

Date

Transaction

01 May

Opening Balance

100

2.00

200

100

200

03 May

Receipt

400

2.10

840

500

1040

04 May

Issue

(100)

2.00

(200)

(100)

2.10

(210)

300

630

09 May

Receipt

300

2.12

636

600

1266

11 May

Issue

(300)

2.10

(630)

(100)

2.12

(212)

200

424

18 May

Receipt

100

2.40

240

300

664

20 May

Issue

(100)

2.12

(212)

200

452

Closing inventory value =

£452

Total value of issues =

£1464 (200 + 210 + 630 + 212 + 212)

3.2.1 Advantages and disadvantages of the FIFO method Advantages

Disadvantages

It is a logical pricing method, which probably represents what is physically happening: in practice the oldest inventory is likely to be used first.

FIFO can be cumbersome to operate because of the need to identify each batch of material separately.

It is easy to understand and explain to managers.

Managers may find it difficult to compare costs and make decisions when they are charged with varying prices for the same materials.

The inventory valuation can be near to a valuation based on replacement cost (as the inventory value will be based on more recent prices)

In a period of high inflation, inventory issue prices will lag behind current market value.

3.3 LIFO (last in, first out) LIFO assumes that materials are issued out of inventory in the reverse order from that in which they were delivered → hence, the most recent deliveries are issued before earlier ones, and issues are priced accordingly.

Management Infor mation

2 : Calcula tin g unit co st ( part 1 )

Using LIFO, complete the missing data from the table below.

INTERACTIVE QUESTION 2: LIFO

[DIFFICULTY LEVEL: INTERMEDIATE] Quantity

Unit value (£)

Total value (£)

Balance (units)

Balance (£)

Opening Balance

100

2.00

200

100

200

03 May

Receipt

400

2.10

840

500

1040

04 May

Issue

09 May

Receipt

11 May

Issue

18 May

Receipt

20 May

Issue

Date

Transaction

01 May

Closing inventory value = £ Total value of issues = £

3.3.1 Advantages and disadvantages of the LIFO method Advantages

Disadvantages

Inventories are issued at a price which is close to current market value.

The method can be cumbersome to operate because it sometimes results in several batches being only part-used in the inventory records before another batch is received.

Managers are continually aware of recent costs when making decisions, because the costs being charged to their department or products will be current costs.

LIFO is often the opposite of what is physically happening and can therefore be difficult to explain to managers.

As with FIFO, decision-making can be difficult because of the variations in prices.

3.4 Cumulative weighted average pricing The cumulative weighted average pricing method calculates a weighted average price for all units in inventory at the point the issuance is made.

Issues are priced at this average cost, and the balance of inventory remaining would have the same unit valuation. The average price is determined by dividing the total cost by the total number of units.

A new weighted average price is calculated whenever a new delivery of materials is received into store. This is the key feature of cumulative weighted average pricing.

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Management Infor mation

2 : Calculating unit co st ( part 1 )

WORKED EXAMPLE: CUMULATIVE WEIGHTED AVERAGE PRICING Issue costs and closing inventory values in section 2.4 would be as follows.

Quantity

Unit value (£)

Total value (£)

Balance (units)

Balance (£)

Date

Transaction

01 May

Opening Balance

100

2.00

200

100

200

03 May

Receipt

400

2.10

840

500

1040

04 May

Issue

(200)

2.08

(416)

300

624

09 May

Receipt

300

2.12

636

600

1260

11 May

Issue

(400)

2.10

(840)

200

420

18 May

Receipt

100

2.40

240

300

660

20 May

Issue

(100)

2.20

(220)

200

440

Average value *2.08 *2.10 *2.20

* A new inventory value per unit is calculated whenever a new receipt of materials occurs.

Closing inventory value =

£440

Total value of issues =

£1476 (416 + 840 + 220)

3.4.1 Advantages / Disadvantages of cumulative weighted average Advantages

Disadvantages

Fluctuations in prices are smoothed out, making it easier to use the data for decision-making.

The resulting issue price is rarely an actual price that has been paid and can run to several decimal places.

It is easier to administer than FIFO and LIFO, because there is no need to identify each batch separately.

Prices tend to lag a little behind current market values when there is gradual inflation.

3.5 Periodic weighted average pricing This average method differs from the cumulative weighted average method. Instead of calculating a new inventory value per unit whenever a receipt occurs, a single average is calculated at the end of the period based on all purchases for the period. Unless stated to the contrary, assume the cumulative method is required in an exam question.

WORKED EXAMPLE: PERIODIC WEIGHTED AVERAGE PRICING Using periodic weighted average pricing, the issue costs and closing inventory of the transactions in section 2.4 would be as follows.

Periodic weighted average price = =

Cost of opening inventory + Total cost of receipts in period Units in opening inventory + Total units received in period (£200 + £1,716) (100 + 800)

= £2.129 per unit

Management Infor mation

2 : Calcula tin g unit co st ( part 1 )

This average price is used to value all the units issued and the units in the closing inventory.

Cost of issues = 700 units × £2.129 Closing inventory value = 200 units × £2.129

£ 1,490 426 1,916

3.6 Comparison of approaches We have seen the following results in the examples so far: Cost of issuances

Closing inventory value

FIFO

£1,464

£452

LIFO

£1,506

£410

Cumulative weighted average

£1,476

£440

Valuation method

Hence, we can conclude that in a period of rising mater ials prices, we will have the following results: Cost of issuances

Closing inventory value

Profit for the period

FIFO

Lowest

Highest

Highest

LIFO

Highest

Lowest

Lowest

Cumulative weighted average

Middle

Middle

Middle

Valuation method

3.7 Profit calculations As mentioned earlier, if the company in question is a retailer (who buys goods and then sells them on without doing further work on them), the cost of the issuances will represent the costs of sale.

In this situation, we can calculate the profits made in the period by deducting the total costs of sale from the sales revenue.

Below we have taken the numbers from our earlier FIFO workings and added in sales prices: Date

Transaction

Quantity

Unit value (£)

Total value (£)

01 May

Opening Balance

100

2.00

200

03 May

Receipt

400

2.10

840

04 May

Sale

(100)

2.00

(200)

(100)

2.10

(210)

09 May

Receipt

300

2.12

636

11 May

Sale

(300)

2.10

(630)

(100)

2.12

(212)

18 May

Receipt

100

2.40

240

20 May

Sale

(100)

2.12

(212)

Sales price / unit (£)

2.50

2.60

2.65

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Management Infor mation

2 : Calculating unit co st ( part 1 )

We can now calculate the profit for the period as: Revenue Cost of sales Profit

Workings 2.50 × 200 + 2.60 × 400 + 2.65 × 100 410 + 842 + 212

Value £1,805 (£1,464) £341

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Would materials used in negligible amounts be classed as direct or indirect materials?

Can you give an example of a direct labour cost?

Can you give an example of a direct expense?

What are the advantages and disadvantages of the FIFO, LIFO and cumulative weighted average pricing methods?

Under the cumulative weighted average pricing method, when is a new weighted average price calculated?

Yes/No

25

3 Calculating unit cost (part 2)

Topic List 1

Absorption costing

2

Costing methods

Learning objectives 🞂

Calculate unit costs and profits/losses from information provided, using absorption costing

🞂

Select the most appropriate method of costing for a given product or service

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Management Infor mation

26 : Calculating unit co st ( part

26 )

1 Absorption Costing 1.1 Calculating the absorption cost of a cost unit Continuing from chapter 2, we still have the same goal: to calculate the production cost of one unit of our product.

A reminder that the cost card for a sponge cake for BakeCo will look like this: Direct materials: Eggs Sugar Flour Butter Direct labour: Mixing Baking Finishing Prime cost Variable overheads Fixed overheads Full production cost

Quantity

Price / Rate

Cost per unit

0.2 kg 0.225 kg 0.225 kg 0.225 kg

£3.00/kg £2.00/kg £1.20/kg £4.40/kg

£0.60 £0.45 £0.27 £0.99

0.05 hours 0.05 hours 0.10 hours

£10/hour £10/hour £10/hour

0.2 hours 0.2 hours

£0.80/hour £0.60/hour

£0.50 £0.50 £1.00 £4.31 £0.16 £0.12 £4.59

🞂

In chapter 2 we saw how to identify and calculate direct materials costs and direct labour costs per unit of our product.

🞂

In this chapter, we will consider how to calculate the amount of indirect costs (overheads) that should be given to each unit of our product.

🞂

We call this process ‘absorption’ and using absorption costing we will be able to find the full production (or ‘absorption') cost of each unit of our product.

To calculate the full cost of producing an item using absorption costing (sometimes referred to as full costing) it is necessary first to establish its direct cost or prime cost and then to add a fair share of indirect costs or overhead.

There are three stages in determining the share of overhead to be attributed to a cost unit.

(1)

Overhead allocation & apportionment (to split overheads between departments)

(2)

Overhead re-apportionment (to move overheads from service departments to production departments)

(3)

Overhead absorption (to record an amount of overheads against each cost unit)

Management Infor mation

3: Calculati ng unit co st ( part 2 )

The diagram below shows how these stages combine to determine the overall production cost of one cost unit (one sponge cake) for BakeCo: Allocation Direct costs

Production costs

Cost units (sponge cakes)

Production departments Mixing

1. & 2.

Allocation & apportionment

4. Absorption Baking Finishing

Indirect costs Service departments Stores Canteen

3. Re-apportionment

1.2 Overhead allocation & apportionment Before the production overheads of BakeCo can be recorded against the individual cakes produced, they need to be split between the individual departments in BakeCo’s factory: Department

Description

Mixing

Mixes the ingredients together and prepares them for baking.

Baking

Bakes the prepared mixed ingredients.

Finishing

Applies icing / decoration / finishing touches to the bakes goods.

Stores

Stores the raw ingredients used in the products.

Canteen

Where the production staff each lunch.

These departments can also be referred to as cost centres. As mentioned in chapter 1, these can be further split into: 🞂

Production centres (those departments directly involved in the production of the goods – e.g.

Mixing, Baking and Finishing).

🞂

Service centres (the departments not directly involved in the production of the goods, but which support the production departments – e.g. Stores and Canteen).

1.2.1 Stage 1: allocation of overheads Allocation is the process by which whole cost items are charged direct to a specific cost centre. 🞂

For example, the salary of the mixing department supervisor would be allocated to the mixing department (as it only relates to that department).

1.2.2 Stage 2: apportionment of overheads The next step in absorption costing is overhead apportionment (giving portions of a specific shared overhead cost to several different cost centres).

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Management Infor mation

28 : Calculating unit co st ( part

28 )

Overhead costs should be shared out on a fair basis. The bases of apportionment for the most usual cases are given below: Overhead

Basis for apportionment

Rent, rates, heating and light, depreciation of buildings

Floor area occupied by each cost centre

Depreciation, insurance of equipment

Cost or book value of equipment

Personnel office, canteen, welfare, wages, first aid

No. of employees or labour hours worked in each cost centre

Heating, lighting

Volume occupied by each cost centre

Once a basis for apportionment has been determined for a specific overhead cost, you can calculate the share of the cost relating to an individual cost centre as follows: Overhead apportioned to cost centre = total overhead cost × 🞂

Apportionment base value for that centre Total apportionment base value

For example, if the mixing department uses 3,000 m2 of a total of 15,000 m2 of factory floor space and the total factory rental cost for the period is £10,000, the mixing department should have the following cost apportioned to it: £10,000 ×

3,000 15,000

= £2,000

INTERACTIVE QUESTION 1: OVERHEAD APPORTIONMENT

[DIFFICULTY LEVEL: INTERMEDIATE]

McQueen Co has incurred the following overhead costs. £’000 100 60 150 80 20 39 26 90 565

Depreciation of factory Factory repairs and maintenance Factory office costs (treat as production overhead) Depreciation of equipment Insurance of equipment Heating Lighting Canteen

Information relating to the production and service departments in the factory is as follows.

Department Floor space (square metres) Volume (cubic metres) Number of employees Book value of equipment

Production 1 1,200 3,000 30 £300,000

Production 2 1,600 6,000 30 £200,000

Service 100 800 2,400 15 £100,000

Service 101 400 1,600 15 £200,000

Total 4,000 13,000 90 £800,000

The overhead costs are apportioned using the following general formula: Overhead apportioned to cost centre = total overhead cost × *For example, heating for production department 1: £39,000 ×

3,000 13,000

= £9,000

Apportionment base value for that centre Total apportionment base value

Management Infor mation

3: Calculati ng unit co st ( part 2 )

Complete the remainder of this table: Cost

Basis of apportionment

Total cost

P1

P2

S 100

S 101

£'000

£'000

£'000

£'000

£'000

Factory depreciation

Floor area

100.0

30.0

40.0

20.0

10.0

Factory repairs

Floor area

60.0

18.0

24.0

12.0

6.0

Factory office costs

No of emps

150.0

50.0

50.0

25.0

25.0

Equipment depreciation

Book value

80.0

30.0

20.0

10.0

20.0

Equipment insurance

Book value

20.0

7.5

5.0

2.5

5.0

Heating

Volume

39.0

*9.0

18.0

7.2

4.8

Lighting

Volume

26.0

Canteen

No of emps

90.0

Total

565.0

Workings:

INTERACTIVE QUESTION 2: APPORTIONING OVERHEADS

[DIFFICULTY LEVEL: INTERMEDIATE]

Pippin Co has two production departments (forming, and assembly) and two service departments (maintenance and general).

The following is an analysis of budgeted overhead costs for the forthcoming twelve-month period. £ Rent & rates Light & heat Depreciation Departmental expenses: Forming Assembly Total production overhead costs

£ 8,000 5,000 10,000

8,500 100 8,600 31,600

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Management Infor mation

3: Calculatin g unit co st ( part 2 )

Other available data are as follows: Department Forming Assembly Maintenance General Total

Floor Area m² 6,000 3,000 500 500 10,000

Plant Value £ 85,000 7,500 7,500 – 100,000

Using direct allocation where possible, and the most appropriate apportionment basis where direct allocation is not possible, complete the overhead cost of each department in the table below: Basis

Forming

Assembly

Maint.

General

Total

£

£

£

£

£

Rent & rates

8,000

Light & heat

5,000

Depreciation

10,000

Departmental expenses

8,600

Total

31,600

Workings:

Management Infor mation

3: Calculati ng unit co st ( part 2 )

1.2.3 Stage 3: re-apportionment of overheads Having successfully split the production overheads between the various cost centres, we need to consider how to record these costs vs. individual cost units: 🞂

The idea behind stage 4 (absorption) is that we will give the cost units a fair share over overheads from each centre based on the resource the cost unit consumes in each cost centre.

🞂

However, cost units will only pass through (and consume resources in) production cost centres (Mixing, Baking and Finishing for BakeCo).

🞂

Hence, we must move (‘re-apportion’) the overheads currently sitting in the service cost centres (Stores and Canteen) into the production cost centres.

🞂

This re-apportionment is performed as follows: –

We first re-apportion the costs from the service cost centre with the largest overheads.

–

The re-apportionment to the other cost centres is based on the extent to which they make use of the service cost centre (e.g. based on number of employees in the below example) and after re-apportionment no cost will remain in the service cost centre.

WORKED EXAMPLE: SERVICE CENTRE COST APPORTIONMENT Overhead (£) No of emps

A 3,160 10

B 4,730 20

C 2,860 10

Canteen 2,320 10

Admin 2,800 5

The above figures represent production overheads which have already been allocated and apportioned to 5 cost centres (A,B and C are production cost centres, Canteen & Admin represent service cost centres). 🞂

The first apportionment is for the service cost centre with the largest costs. These are shared between all the other cost centres, including the other service cost centre, on a fair basis.

🞂

The costs of the second service cost centre, which will now include some of the first service cost centre’s costs, are apportioned between the production cost centres, on a fair basis. This is illustrated below:

Overhead (£) Apportion Admin (£) Apportion Canteen (£) Total (£)

A 3,160 560 720 4,440

B 4,730 1,120 1,440 7,290

C 2,860 560 720 4,140

Canteen 2,320 560 (2,880) 0

Admin 2,800 (2,800) – 0

Points to note 1

The costs of the administration department were taken first because these are the largest service centre costs. The basis of apportionment selected is number of employees, since administration costs are largely personnel-related.

2

The costs of the canteen have also been apportioned on the basis of number of employees, because canteen work is primarily employee-related.

3

Service centre costs must ultimately be apportioned to the production cost centres; otherwise there will be no mechanism for absorbing the costs into the cost of output units.

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Management Infor mation

3: Calculatin g unit co st ( part 2 )

1.3 Overhead absorption Having allocated and/or apportioned all overheads such that all production overheads are now split between the various production cost centres, the next stage in absorption costing is to give each cost unit a fair share of each production cost centre’s costs (‘overhead absorption’). 🞂

In order to do this, we need to calculate an Overhead Absorption Rate (OAR) for each cost centre, which will dictate how much overhead is attributed to each cost unit.

Note: non-production overheads (such as administration, selling and distribution overheads) are not absorbed into individual cost units – only production overheads are absorbed into individual cost units.

1.3.1 Predetermined OARs As mentioned earlier, overhead absorption rates are calculated for each production cost centre based on: (1)

the total production overhead cost in that cost centre, and

(2)

the level of activity in that cost centre (the ‘absorption base’)

The OAR for a cost centre is then calculated as: Total production overhead cost Total activity level

🞂

In order to be able to calculate the production cost of cost units on a daily / weekly basis, we need to calculate OARs for each production cost centre at the beginning of the period (e.g. the start of the month / quarter).

🞂

Hence, when calculating the OARs for the period, we will use the budgeted overhead costs and the budgeted activity levels for the coming period (hence they are referred to as ‘predetermined OARs’). This is more convenient and avoids OAR fluctuations during the period.

🞂

Hence, the predetermined OAR is calculated as

Total budgeted production overhead cost Total budgeted activity level

1.3.2 Selecting the appropriate absorption base Management should try to establish an absorption rate that provides a reasonably accurate estimate of overhead costs for jobs, products or services. 🞂

Hence the activity level (absorption base) used in the OAR calculations should reflect the nature of the activities in that cost centre (the ‘cost driver’).

🞂

In the table below we have shown commonly used absorption bases and when to use them:

Absorption base

When to use them

Number of units produced

When all of the products made in that cost centre are identical (in terms of resource use)

Number of labour hours worked

When the work in the cost centre is mostly manual labour intensive

Number of machine hours used

When the work in the cost centre is mostly automated

Direct materials cost Direct labour cost Total direct cost

Where labour / machine hour data is not readily available (but cost data is)

Management Infor mation

3: Calculati ng unit co st ( part 2 )

INTERACTIVE QUESTION 3: OVERHEAD ABSORPTION RATES

[DIFFICULTY LEVEL: EASY]

Use the following information to determine suitable overhead absorption rates for a company’s three production cost centres.

Forming 13,705 5,482 1,350

Budgeted cost centre overheads (£) Budgeted direct labour hours per annum Budgeted machine hours per annum

Machining 28,817 790 5,240

Assembly 9,978 4,989 147

(a)

The forming department rate is £ (delete as appropriate)

per direct labour hour/ machine hour

(b)

The machining department rate is £ (delete as appropriate)

per direct labour hour/ machine hour

(c)

The assembly department rate is £ (delete as appropriate)

per direct labour hour/ machine hour

1.4 Blanket absorption rates Where blanket absorption rates are used, one OAR is calculated for the entire factory (rather than calculating separate OARs for each production centre). 🞂

These are only suitable where there are no major differences between the nature of the work in each of the different production cost centres.

1.5 Over and under absorption of overheads Having calculated a predetermined OAR for each production cost centre, we will use this OAR to record the production costs of each cost unit produced in our accounting ledger during the period.

However, it is likely that the use of a pre-determined OAR (based on budgeted numbers) to record costs in our accounting ledger will lead to the over or under-recording of costs (known as ‘over/under absorption’):

WORKED EXAMPLE: OVER/UNDER ABSORPTION Suppose that BakeCo estimated the following for the next period for its Finishing department: 🞂

A budgeted production overhead of £15,000

🞂

A budgeted activity level of 1,000 hours worked (labour hours used, as the work in the finishing department is mostly manual).

🞂

Hence, the pre-determined OAR is

£15,000 1,000 hours

= £15/labour hour

At the end of the period, BakeCo determines that: 🞂

The actual production overhead for the period was £16,500

🞂

The actual labour hours worked were 970 hours

During the period, each time another labour hour was worked in the finishing department, BakeCo recorded a cost of £15 in its ledger.

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3: Calculatin g unit co st ( part 2 )

🞂

Hence, by the end of the period, 970 hours × £15 = £14,550 of overhead cost has been recorded in BakeCo’s ledger

🞂

However, we know that £16,500 of overheads have actually been incurred.

🞂

Hence, we have under-recorded (‘under-absorbed’) the overhead costs in the Finishing department by £14,550 – £16,500 = –£1,950

🞂

Therefore, we must record an addition cost of £1,950 in our ledger (by debiting the income statement) – this is known as an under-absorption adjustment.

The general result is that over/under absorption is calculated as follows: 🞂

🞂

Overhead absorbed (actual activity level × predetermined OAR) less actual overhead –

If the result is negative then overheads have been under-absorbed (so the income statement must be debited with an adjustment to increase costs / reduce profits).

–

If the result is positive then the overheads have been over-absorbed (so the income statement must be credited with an adjustment to reduce costs / increase profits).

Over / under absorption is caused by the following factors:

Factor

On its own this would cause

Over-estimation of the overhead cost in the budget

Over-absorption

Under-estimation of the overhead cost in the budget

Under-absorption

Over-estimation of the activity level in the budget

Under-absorption

Under-estimation of the activity level in the budget

Over-absorption

WORKED EXAMPLE: OVER AND UNDER ABSORPTION OF OVERHEADS Suppose that the budgeted production overhead in a production department is £80,000 and the budgeted activity is 40,000 direct labour hours. The overhead absorption rate (using a direct labour hour basis) would be £2 per direct labour hour.

Actual production overheads in the period are, say, £84,000, and 45,000 direct labour hours are worked.

Overhead incurred (actual) Overhead absorbed (45,000 × £2) Over absorption of overhead

£ 84,000 90,000 6,000

In this example, the cost of produced units or jobs has been charged with £6,000 more than was actually spent. 🞂

An adjustment to reconcile the overheads charged to the actual overhead is necessary and the over absorbed overhead will be written as a credit to the income statement at the end of the accounting period.

🞂

By making this adjustment the total overhead recorded in the ledger would be reduced to £84,000, matching the overhead cost actually incurred.

🞂

The over-absorption was caused by an under-estimation of the activity for the period, which counteracted an under-estimation of the overhead for the period.

Management Infor mation

3: Calculati ng unit co st ( part 2 )

INTERACTIVE QUESTION 4: UNDER AND OVER ABSORPTION OF OVERHEAD

[DIFFICULTY LEVEL: EASY]

Using your answer to Interactive question 3 and the following information, determine whether the overhead in each of the three production departments is under or over absorbed and by how much for the year.

Actual direct labour hours Actual machine hours Actual overhead

Forming 5,370 1,300 13,900

Machining 950 6,370 £30,300

(a)

The overhead in the forming department is under/over* absorbed by £

(b)

The overhead in the machining department is under/over* absorbed by £

(c)

The overhead in the assembly department is under/over* absorbed by £

Assembly 5,400 100 £8,500

* Delete as applicable WORKING

2 Costing methods So far, we have mostly considered costing cost units produced as part of our general production (a large quantity of similar goods made for general sale).

However, in reality we may encounter other scenarios where a slightly different approach is required.

2.1 Specific order costing 2.1.1 Job costing Job costing is appropriate where each separately identifiable cost unit or job is of relatively short duration, such as plumbing services.

Each job would be allocated a separate job number and costs would be accumulated against this number in order to determine the total cost of the job. 🞂

Issues of direct material would be charged to each job using FIFO or LIFO, etc.

🞂

Direct labour charges would be determined from detailed time records kept for each employee.

🞂

Overhead costs would be absorbed into the total cost of each job using the predetermined overhead absorption rate for each cost centre through which the job passes.

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Management Infor mation

3: Calculatin g unit co st ( part 2 )

2.1.2 Contract costing Contract costing is appropriate where each separately identifiable cost unit is of relatively long duration, such as the building of the school or hospital.

Each contract would be allocated a separate number and costs would be accumulated against this number in order to determine the total cost of the contract.

2.1.3 Batch costing Batch costing is similar to job costing except that each separately identifiable cost unit would be a batch of identical items.

For example, batch costing can be applied when production takes the form of separately identifiable batches of shoes or batches of printed advertising leaflets.

2.1.4 Process (continuous operation) costing Some organisations have a continuous flow of operations and produce a large number of identical products. Food processing, paint production and oil refining are all examples.

Such operations often consist of a number of consecutive processes where the output of one process becomes the input of the subsequent process and so on until the finished output is produced.

INTERACTIVE QUESTION 5: COSTING METHODS

[DIFFICULTY LEVEL: EASY]

Indicate in the space provided below one costing method that would be appropriate in each of the following industries.

Process

Job

Contract

Batch

Fitting kitchens Manufacturing components Manufacturing chemicals Building offices

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Do you know the three stages in determining the share of overhead to be attributed to a cost unit?

Can you explain what allocation is?

Can you select suitable bases of apportionment?

Can you explain the reasons for under/over absorbed overheads?

Do you know when process, job, contract and batch costing are used?

Yes/No

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4 Marginal costing and absorption costing

Topic List 1

Calculating profits and valuing inventory using absorption costing

2

Calculating profits and valuing inventory using marginal costing

3

Marginal costing and absorption costing compared

Learning objectives 🞂

Calculate unit costs and profits/losses from information provided, using marginal and absorption costing

🞂

Calculate and reconcile profits under absorption costing or marginal costing

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4: Marginal co st i ng and absor ption costing

1 Absorption costing In the previous chapter we saw how to calculate the production cost of one cost unit using absorption costing.

In this chapter, we will discuss how to use that information to calculate the profit or loss for a business and value their inventory using absorption costing.

1.1 Profit calculations and inventory valuations using absorption costing Profit calculations When calculating the absorption costing profit for the period, we can follow the following template calculation (assuming a single product is produced and the overhead absorption basis is number of units produced): Profit line

Calculation

£

Revenue

Actual units sold × sales price/unit

£ X

Cost of sales Production cost

Actual units produced × full production cost/unit

X

Add: opening inventory

Opening inventory units × full production cost/unit

X

Less: closing inventory

Closing inventory units × full production cost/unit

(X) (X)

Fixed O/H over/under absorption

Actual units prod. × predetermined OAR – actual fixed O/H

X/(X)

Non-production costs

(X)

Profit/loss

X/(X)

Inventory valuations Under absorption costing inventory of finished goods is valued based on the full production cost of those units (including absorbed fixed production overheads).

WORKED EXAMPLE: ABSORPTION COSTING PROFIT CALCULATIONS Imagine a simplified situation for BakeCo where they only make one product (sponge cakes).

We are given the following standard cost card for sponge cakes (which is unchanged from the prior period) and provided with some additional information: Eggs Sugar Flour Butter Direct labour Variable overheads

Quantity 0.2 kg 0.225 kg 0.225 kg 0.225 kg 0.2 hours 0.2 hours

Price / Rate £3.00/kg £2.00/kg £1.20/kg £4.40/kg £10/hour £0.80/hour

Cost per unit £0.60 £0.45 £0.27 £0.99 £2.00 £0.16 £4.47

Management Infor mation

4: Marginal co st i ng and ab sorption costing

BakeCo had the following budgeted and actual figures for the quarter: Sales volume (units) Production volume (units) Fixed production overheads Variable non-production costs (per unit sold) Fixed non-production costs Sales price (per unit)

Budgeted 14,000 15,000 £12,000 £1.40 £21,000 £12

Actual 16,500 17,800 £13,500 £1.50 £22,250 £12

BakeCo ended the prior quarter with 500 units of closing inventory (finished cakes ready for sale) and absorbs fixed production overheads into its cost units using units produced as the absorption base.

Requirement Calculate the profit for the quarter and the closing inventory value using absorption costing.

SOLUTION Before we can calculate the profit for the quarter, we need to complete the cost card by calculating the fixed production overhead to be absorbed into each unit (the predetermined overhead absorption rate):

Predetermined OAR =

Total budgeted fixed production overhead Total budgeted activity level

=

£12,000 15,000

= £0.80

Hence, the full production cost per unit is £4.47 + £0.80 = £5.27 per unit.

We can now calculate the profit for the quarter: Profit line Revenue Cost of sales Production cost Add: opening inventory Less: closing inventory

Calculation 16,500 × £12

Fixed O/H over/under absorption Variable non-production costs Fixed non-production costs Profit for the quarter

17,800 × £0.80 – £13,500 (W2) 16,500 × £1.50

17,800 × £5.27 500 × £5.27 1,800 × £5.27 (W1)

£

£ 198,000

93,806 2,635 (9,486) (86,955) 740 (24,750) (22,250) 64,785

(W1) Closing inventory valuation Closing inventory = opening inventory + units produced – units sold = 500 + 17,800 – 16,500 = 1,800 This is then valued at the full production cost per unit = 1,800 × £5.27 = £9,486 (W2) Over-absorption calculation Per the above calculation, we will absorb £0.80 of fixed production overhead into each unit we produce. We produced 17,800 units, so we absorbed 17,800 × £0.80 = £14,240 of fixed production overheads during the quarter.

We only incurred £13,500 of fixed production overheads, so we over-absorbed (over-recorded) our fixed production overheads by £14,240 – £13,500 = £740 → this therefore needs to be credited to the income statement.

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Management Infor mation

1.2 Short-cut absorption profit calculations In the long-form scenario-based questions which cover absorption costing, you will often be required to complete a profit calculation template (similar to that in the previous example).

However, in short-form questions it is useful to have a short-cut approach to use.

Profit line

Calculation

£

Revenue

Actual units sold × sales price/unit

X

Cost of sales

Actual units sold × full production cost/unit

(X)

Fixed O/H over/under absorption

Actual units prod. × predetermined OAR – actual fixed O/H

X/(X)

Non-production costs

(X)

Profit/loss

X/(X)

Note: this only works in scenarios where the full production cost per unit remains unchanged from the previous period.

This approach would work as follows for the BakeCo profit calculation: Profit line

Calculation

£

Revenue

16,500 × £12

198,000

Cost of sales

16,500 × £5.27

(86,955)

Fixed O/H over/under absorption

17,800 × £0.80 – £13,500 (W2)

Variable non-production costs

16,500 × £1.50

740 (24,750)

Fixed non-production costs

(22,250)

Profit for the quarter

64,785

2 Marginal cost and marginal costing 2.1 Marginal costing Marginal costing is an alternative costing system to absorption costing.

With marginal costing, only variable production costs (material, labour and overheads) are included in the valuation of cost units.

All fixed costs are treated as period costs and are charged in full in the income statement for the period.

2.2 Contribution Contribution is an important measure in marginal costing, and it is calculated as the difference between sales value and marginal (or variable) cost.

The term ‘contribution’ is actually short for ‘contribution towards fixed overheads and profit’ and is a key measure to be used in decision-making later on in MI – see chapter 5 (transfer pricing) and chapter 10 (breakeven and limiting factor analysis).

Management Infor mation

4: Marginal co st i ng and ab sorption costing

The contribution per unit can be calculated as follows: £ Selling price Variable materials Variable labour Variable prod overhead Marginal production cost Variable selling, distribution & admin costs Total marginal cost Contribution

£

£ X

(X) (X) (X)

INTERACTIVE QUESTION 1: CONTRIBUTION

(X) (X) (X) X

[DIFFICULTY LEVEL: EASY]

A particular electrical good is sold for £1,009.99. The variable material cost per unit is £320, the variable labour cost per unit is £192 and the variable production overhead cost per unit is £132. Fixed overheads per annum are £100,000 and the budgeted production level is 1,000 units.

The contribution per unit of the electrical good is £

2.3 Profit calculations and inventory valuations using marginal costing Profit calculations When calculating the marginal costing profit for the period, we can follow the following template calculation: Profit line

Calculation

Revenue

Actual units sold × sales price/unit

£

£ X

Cost of sales Production cost

Actual units produced × variable production cost/unit

X

Add: opening inventory

Opening inventory units × variable production cost/unit

X

Less: closing inventory

Closing inventory units × variable production cost/unit

(X) (X)

🞂

Variable non-production costs

(X)

Contribution

X

Fixed production costs

(X)

Fixed non-production costs

(X)

Profit/loss

X/(X)

Note that the key differences to absorption costing are: –

Cost units are valued at the variable production cost per unit

–

Fixed production costs are treated as period costs (so there is no absorption of fixed production overheads into the cost units and no over/under absorption calculations).

–

Inventory of finished goods is valued using the variable production cost of those units.

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WORKED EXAMPLE: MARGINAL COSTING PROFIT CALCULATIONS Let us now revisit the earlier BakeCo example: A reminder of the information we were given for BakeCo: Eggs Sugar Flour Butter Direct labour Variable overheads

Quantity 0.2 kg 0.225 kg 0.225 kg 0.225 kg 0.2 hours 0.2 hours

Price / Rate £3.00/kg £2.00/kg £1.20/kg £4.40/kg £10/hour £0.80/hour

Cost per unit £0.60 £0.45 £0.27 £0.99 £2.00 £0.16 £4.47

BakeCo had the following budgeted and actual figures for the quarter: Sales volume (units) Production volume (units) Fixed production overheads Variable non-production costs (per unit sold) Fixed non-production costs Sales price (per unit)

Budgeted 14,000 15,000 £12,000 £1.40 £21,000 £12

Actual 16,500 17,800 £13,500 £1.50 £22,250 £12

BakeCo ended the prior quarter with 500 units of closing inventory (finished cakes ready for sale).

Requirement Calculate the profit for the quarter and the closing inventory value using marginal costing.

SOLUTION Profit line Revenue Cost of sales Production cost Add: opening inventory Less: closing inventory

Calculation 16,500 × £12

Variable non-production costs Contribution Fixed production costs Fixed non-production costs Profit for the quarter

16,500 × £1.50

17,800 × £4.47 500 × £4.47 1,800 × £4.47 (W1)

£

£ 198,000

79,566 2,235 (8,046) (73,755) (24,750) 99,495 (13,500) (22,250) 63,745

(W1) Closing inventory valuation Closing inventory = opening inventory + units produced – units sold = 500 + 17,800 – 16,500 = 1,800 This is then valued at the variable production cost per unit = 1,800 × £4.47 = £8,046

Management Infor mation

4: Marginal co st i ng and ab sorption costing

2.4 Short-cut marginal profit calculations In the long-form scenario-based questions which cover marginal costing, you will often be required to complete a profit calculation template (similar to that in the previous example).

However, in short-form questions it is useful to have a short-cut approach to use Profit line

Calculation

£

Contribution

Actual units sold × (sales price/unit – all variable costs/unit)

X

Any fixed costs

(X)

Profit/loss

X/(X)

Note: this only works in scenarios where the variable production cost per unit remains unchanged from the previous period.

This approach would work as follows for the BakeCo profit calculation: Profit line

Calculation

£

Contribution

16,500 × (£12 – £4.47 - £1.50)

99,495

Fixed production costs

(13,500)

Fixed non-production costs

(22,250)

Profit for the quarter

63,745

3 Marginal costing and absorption costing compared 3.1 Summarising the differences between the two costing methods Absorption costing

Marginal costing

Cost unit / inventory valuation

Full production cost (including absorbed fixed production overheads)

Variable production cost

Treatment of fixed production costs

Absorbed into cost units

Treated as period costs

Other notes

Over/under absorption adjustment needed

Contribution = revenue less variable costs

3.2 Reconciling between absorption and marginal profits Looking back at the two profit calculations we performed for BakeCo, you will notice that the profit and closing inventory values are different depending on the costing method used: Total profit Closing inventory value (total) Closing inventory value (per unit)

Absorption costing £64,785 £9,486 £5.27

Marginal costing £63,745 £8,046 £4.47

Difference £1,040 £1,440 £0.80

The reason for the differences is: 🞂

Under absorption costing BakeCo are including an extra £0.80 of cost (from absorbed fixed production overheads) into each unit of product produced.

🞂

Hence, each of the 1,800 units of closing inventory are valued £0.80 higher under absorption costing than under marginal costing → 1,800 × £0.80 = £1,440 (the difference in inventory values).

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4: Marginal co st i ng and absor ption costing

🞂

BakeCo increased their inventory levels by 1,300 units during the quarter (they produced 17,800 units and only sold 16,500 units). Each one of these additional units produced had £0.80 of fixed production overheads included in its value under absorption costing (which would have been charged to the income statement under marginal costing) → 1,300 × £0.80 = £1,040 (the difference in profits).

General result When reconciling between absorption and marginal costing profits, we have the following general results: 🞂

Absorption profit = Marginal profit + change in inventory (units) × OAR per unit –

🞂

For BakeCo: £64,785 = £63,745 + 1,300 × £0.80

Marginal profit = Absorption profit – change in inventory (units) × OAR per unit –

For BakeCo: £63,785 = £64,785 – 1,300 × £0.80

Hence, this means that: 🞂

In periods where inventory levels rise, Absorption profits > Marginal profits

🞂

In periods where inventory levels fall, Marginal profits > Absorption profits

INTERACTIVE QUESTION 2: RECONCILING THE DIFFERENCE IN REPORTED PROFITS The overhead absorption rate for product X is £10 per machine hour. Each unit of product X requires five machine hours.

Production of product X last period was 4,800 units and the sales volume achieved was 4,750 units. (a)

The absorption costing profit would be (delete as appropriate): Greater than / The same as / less than the marginal costing profit.

(b)

The differences between the reported profits would be £

INTERACTIVE QUESTION 3: MARGINAL AND ABSORPTION COSTING

[DIFFICULTY LEVEL: HARD]

X plc commenced business on 1 March making one product only. Unit cost information for the product is as follows.

Variable labour Variable material Variable production overhead Fixed production overhead Standard production cost

£ 5 8 2 5 20

The fixed production overhead figure has been calculated on the basis of a budgeted normal output of 36,000 units per annum.

You are to assume that all the budgeted fixed expenses are incurred evenly over the year. March and April are to be taken as equal period months. All fixed costs are also actually incurred as budgeted.

Selling, distribution and administration expenses are as follows.

Fixed £120,000 per annum Variable 15% of the sales value

Management Infor mation

4: Marginal co st i ng and ab sorption costing

The selling price per unit is £35 and the number of units produced and sold was as follows.

March Units 2,000 1,500

Production Sales

April Units 3,200 3,000

Requirement (a)

If a marginal costing system is in operation: (i)

The value of the closing inventory for each month will be: March £ April £

(b)

(ii)

The loss reported for March will be £

(iii)

The profit reported for April will be £

If an absorption costing system is in operation: (i)

The value of the closing inventory for each month will be: March £ April £

(ii)

The production overhead for March will be under/over* absorbed by £ *delete as appropriate

(iii)

The production overhead for April will be under/over* absorbed by £ *delete as appropriate

(iv)

The loss reported for March will be £

(v)

The profit reported for April will be £

WORKING

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Management Infor mation

Management Infor mation

4: Marginal co st i ng and ab sorption costing

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Management Infor mation

3.3 Marginal costing and absorption costing compared (a)

(b)

Advantages of absorption costing (i)

Fixed production costs are incurred in order to make output; it is therefore 'fair' to charge all output with a share of these costs.

(ii)

Closing inventory values, by including a share of fixed production overhead, will be valued on the principle required by accounting standards for the financial accounting valuation of inventories for external reporting purposes.

(iii)

A problem with calculating the contribution of various products made by a company is that it may not be clear whether the contribution earned by each product is enough to cover fixed costs, whereas by charging fixed overhead to a product it is possible to ascertain whether or not it is profitable.

Advantages of marginal costing (i)

It is simple to operate.

(ii)

There are no apportionments of fixed costs, which are frequently done on an arbitrary basis. Many costs, such as the managing director's salary, are indivisible by nature.

(iii)

Fixed costs will be the same regardless of the volume of output, because they relate to a period of time and are period costs. It makes sense, therefore, to charge them in full as a cost to the period.

(iv)

The cost to produce an extra unit is the variable production cost. It is realistic to value closing inventory items at this directly attributable cost.

(v)

Under or over absorption of overheads is avoided.

(vi)

Marginal costing information can be more useful for decision-making since it focuses on the variable costs that are most likely to be altered as the result of a decision.

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you explain how fixed costs are treated in marginal costing systems?

Do you know how contribution is calculated?

Can you identify the differences between marginal and absorption costing?

Are you able to explain the advantages and disadvantages of marginal costing?

Yes/No

49

5 Pricing calculations

Topic List 1

Pricing approaches

2

Cost-plus pricing

3

Mark-ups and margins

4

Transfer pricing

Learning objectives 🞂

Calculate the sales price for a given product or service using cost based pricing

🞂

Calculate transfer prices for specified sales to internal customers which take account of appropriate costs

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Management Infor mation

5: Pricing calculatio ns

1 Pricing approaches Having spent chapters 1 – 4 determining the cost of a unit of our product (cost unit), we now need to consider how much we should charge our customers – we need to calculate a selling price.

In this chapter we will see two main approaches to setting a selling price: 🞂

Cost-plus pricing (or the ‘mark-up’ approach)

🞂

Profit margins

2 Cost-plus pricing 2.1 What is cost-plus pricing?

We will start by considering cost-plus pricing: 🞂

Cost-plus pricing involves determining the cost of one cost unit and then increasing that by a percentage (a ‘mark-up’).

🞂

Hence the sales price = cost + % mark-up x cost = cost x (1+% mark-up)

🞂

Hence, if our product costs £10 to produce and we want to apply a 20% mark-up when calculating the selling price, the selling price would be £10 + 0.2 × £10 = £10 × 1.2 = £12

🞂

However, as we have seen in the previous chapters, there are different ways of calculating the cost and this will have an impact on the selling price we calculate – we could use any of the following approaches: – – –

Full production cost + a mark-up Full production cost + non-production costs + a mark-up Marginal cost + a mark-up

2.2 Full cost-plus pricing Calculating a full cost-plus price will first involve determining what the full cost is – hence you will likely need to deal with overhead absorption to calculate the full cost.

Using the BakeCo information from the previous chapter, we had determined the following full production cost of one sponge cake (having calculated the absorbed fixed production overhead): Eggs Sugar Flour Butter Direct labour Variable overheads Fixed overheads Full production cost

Cost per unit £0.60 £0.45 £0.27 £0.99 £2.00 £0.16 £0.80 £5.27

Hence, if BakeCo wanted to set a selling price based on a mark-up of 40% on full production cost, they would set a price of £5.27 × 1.4 = £7.38

Management Infor mation

5: Pricing calculatio ns

WORKED EXAMPLE: CALCULATING A COST-PLUS SELLING PRICE £ per unit 14.00 54.00 13.50 81.50

Variable materials Variable labour at £12 per hour Variable production overheads at £3 per hour Variable production cost per unit

Fixed production overheads are budgeted to be £69,000 each period. The overhead absorption rate will be based on 17,250 budgeted direct labour hours each period.

The company wishes to add 20 per cent to the full production cost in order to determine the selling price per unit for product S.

Step 1 Calculate the fixed production overhead absorption rate.

Overhead absorption rate = £69,000 / 17,250 = £4 per direct labour hour

Step 2 Calculate the full production cost per unit.

Direct labour hours per unit = £54/£12 = 4.5 hours £ per unit 81.50 18.00 99.50

Variable production cost per unit Fixed production overhead absorbed (4.5 hours × £4) Full production cost per unit

Step 3 Add the required mark-up to determine the selling price. £ per unit 99.50 19.90 119.40

Full production cost per unit Mark-up 20% Full cost-plus selling price

2.3 Determining the mark-up applied We may also find situations where a selling price has already been determined and we are asked to determine the % mark-up applied. 🞂

For example, say that BakeCo had set a selling price of £6.85 based on full production cost plus a mark-up.

🞂

We know the full production cost is £5.27, hence £5.27 × (1+ mark-up %) = £6.85

🞂

Hence, 1+ mark-up % = £6.85 / £5.27 = 1.3

🞂

Hence the mark-up = 0.3 or 30%.

This leads to the general result that the mark-up % =

Selling price Full cost

−1

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Management Infor mation

INTERACTIVE QUESTION 1: ADJUSTING THE MARK-UP PERCENTAGE [DIFFICULTY LEVEL: INTERMEDIATE] The full cost of providing a service is £40 per hour and its selling price is currently determined as full cost plus 60%. In each of the following separate situations, calculate the required profit mark-up percentage.

(1)

A competitor launches a similar service for £60 per hour.

In order to sell the service at the same price as the competitor the percentage mark-up must be reduced to:

(2)

The full cost of providing the service increases to £50 per hour. The required mark-up percentage to achieve the same absolute value of mark-up per hour of service provided is:

2.4 Allowing for inflation when setting selling prices The mark-up added to total cost must be sufficient to earn the required profit, or in the case of adding a mark-up to total production cost, the mark-up must be sufficient to recover all non-production costs in addition to earning the required profit. An additional allowance may need to be built in to allow for expected price increases (inflation).

Even if some sort of allowance is added for inflation the seller bears the risk of inflation when a selling price is determined prior to delivery of the goods or services.

However, if the buyer agrees to prices based on actual cost incurred plus a profit mark-up then all of the cost increases caused by inflation can be passed to the buyer. Thus, all of the inflation risk is borne by the buyer. The following points about this pricing policy should be noted. 🞂

The buyer is likely to require some form of assurance that costs are adequately controlled, otherwise the supplier’s cost inefficiencies will be passed directly to the buyer and there is no incentive for the supplier to control costs.

–

The principle of ‘Open Book Accounting‘ can be introduced, where the buyer is given open access to the cost information contained in the accounts of the seller.

🞂

Moreover, the supplier actually has an incentive to overspend, since all costs will be passed to the buyer and a profit mark-up will also be earned on all expenditure by the supplier.

🞂

If a credit period is offered to the buyer then the supplier will bear the inflation risk from the date that the final price is agreed until payment is received from the customer. However, in low inflation economies this additional inflation risk is likely to be acceptable to a supplier.

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2.5 Advantages and disadvantages of full cost-plus pricing The advantages of full cost-plus pricing are as follows.

Advantages of full cost-plus

Disadvantages of full cost-plus

The price is quick and easy to calculate.

It reduces incentives to control costs.

Pricing decisions can be delegated to more junior employees. This is particularly important with jobbing work where many prices must be established and quoted each day.

It fails to recognise that since demand may be determining price, there will be a profitmaximising combination of price and demand.

A price in excess of full cost should ensure that an organisation working at normal capacity will cover all its costs.

It requires arbitrary absorption of overheads into product costs.

Price increases can be justified as costs rise.

2.6 Marginal cost-plus pricing Marginal cost-plus pricing is a method of determining sales prices whereby a profit mark-up is added to either the marginal (i.e. variable) cost of production or the marginal cost of sales.

Hence, based on the below costing information, if BakeCo wanted to set a sales price based on marginal production cost plus a 60% mark-up, it would set a price of £4.47 × 1.6 = £7.15 Cost per unit £0.60 £0.45 £0.27 £0.99 £2.00 £0.16 £0.80 £5.27

Eggs Sugar Flour Butter Direct labour Variable overheads Fixed overheads Full production cost

3 Mark-ups and margins 3.1 The difference between mark-up and margin Having seen how to calculate a price based on cost plus a mark-up %, we need to consider how the % profit we make one sale will be expressed.

This profit can be expressed in two ways: 🞂

% Mark-up (profit shown as a % of the cost)

🞂

% Margin (profit shown as a % of the sales price) Selling price Cost Profit on sale

20% Mark-up 120% of cost 100% of cost 20% of cost

20% Margin 100% of sales price 80% of sales price 20% of sales price

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3.2 Calculating sales prices using mark-ups and margins Regardless of whether we use a mark-up or a margin, the common situation is that we know the cost of our product and need to calculate a sales price → hence we need to know how to calculate a selling price if we are given the cost and either a mark-up or a margin %.

Let’s use the BakeCo data again.

Eggs Sugar Flour Butter Direct labour Variable overheads Fixed overheads Full production cost

Cost per unit £0.60 £0.45 £0.27 £0.99 £2.00 £0.16 £0.80 £5.27

Say BakeCo wanted to calculate a selling price using either a 20% mark-up on full production cost, or a 20% margin: 🞂

Calculating the selling price using a mark-up is easy, as we just need to apply the % mark-up to the cost we’ve been given: Selling price Cost Profit on sale

🞂

Workings £5.27 × 1.2 £5.27 × 0.2

However, calculating the selling price using a margin is more difficult, as the margin is a % of the selling price, rather than the cost.

–

Hence, we need to consider that if we are selling based on a 20% margin, our profit on sale will be 20% of the selling price.

–

Our cost must there for be 80% of the selling price (as price – cost = 20% of price)

–

Hence, our selling price must equal our cost × 100/80

Selling price Cost Profit on sale

🞂

20% Mark-up £6.32 £5.27 £1.05

20% Margin £6.59 £5.27 £1.32

Workings £5.27 × 100 / 80 £6.59 × 0.2

Hence, we have the following standard result to calculate price based on cost: Selling price

Mark-up Cost × (1+% mark-up)

Margin Cost × 100/(100-margin)

WORKED EXAMPLE: THE DIFFERENCE BETWEEN MARK-UP AND MARGIN Product Q incurs a total cost of £80 per unit and its selling price is set at £100 per unit.

The mark-up applied to product Q = (£20/£80) × 100% = 25% of total cost The margin earned by product Q = (£20/£100) × 100% = 20% of sales price

Management Infor mation

INTERACTIVE QUESTION 2: MARK-UPS AND MARGINS

5: Pricing calculatio ns

[DIFFICULTY LEVEL: INTERMEDIATE]

(1)

If the full cost is £14 per unit, calculate the price to achieve a margin of 20% of the selling price.

(2)

The selling price is £27 per unit, determined on the basis of full cost-plus. If the full cost is £18 per unit, calculate the mark-up percentage.

(3)

A selling price of £165 per unit earns a mark-up of 106.25% of the full cost. What is the full cost per unit?

(4)

A product's selling price is determined by adding 33.33% to its full cost. What percentage margin on sales price does this represent?

4 Transfer pricing 4.1 What is a transfer price?

Transfer prices are used on transactions between related parties – e.g.: 🞂

Sales of goods / services between two divisions of the same company

🞂

Sales of goods / services between two companies in the same group

In Management Information we will typically see situations where one division will make a component that can either be sold externally, or transferred to another division to use in another product.

For example, imagine that LecCo (an electronics manufacturer) has two divisions, Alpha and Beta. 🞂

Alpha makes a component (a processor chip called the X) which can be sold externally or transferred to another division (Beta).

🞂

Beta then use this processor chip in a product (the LecFone) which is sold externally.

🞂

The key question is: what transfer price should Alpha charge when it sells units of component X to Beta?

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Transfer price?

Division Alpha

Division Beta Component X

LecFone

External customers

Component X

External customers Because a company / group may want to achieve several different aims through the setting of the transfer price, the transfer price will not necessarily match the typically external selling price of the goods / services.

4.2 Aims of a transfer pricing system As mentioned above, companies and groups will want to achieve several different aims when setting a transfer price: 🞂

To enable the realistic measurement of divisional profit.

🞂

To provide the supplier with a realistic profit and the receiver with a realistic cost.

🞂

To give autonomy to managers.

🞂

To encourage goal congruence, whereby individual managers’ own goals are the same as the goals of the company / group as a whole.

🞂

To ensure profit maximisation for the company / group as a whole.

As we will see, it may be difficult to reconcile all of these aims.

Goal-congruent decision-making In Management Information, a goal-congruent decision is one which maximises the contribution earned by the company / group of companies. 🞂

As you will see over the coming pages, this means that we will disregard any fixed costs when considering the goal congruence of any decisions regarding transfer price, as these will be unaffected by any decisions made in the short-term (as they are fixed).

🞂

Instead, we will focus on variable costs and revenues.

🞂

Hence, when asked about decision-making in transfer pricing questions: –

Division managers will take decisions that increase the contribution of their division.

–

A goal congruent decision for the company is one that increases the contribution of the whole company.

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4.3 Practical methods of transfer pricing 4.3.1 Market price The easiest transfer price to set is a one equal to the market value of the goods being transferred. We need to consider whether this is the optimum transfer price (the one that enables goal-congruent decision making for the divisions). 🞂

If a perfectly competitive market exists for a product, then the external market price (as adjusted for any cost savings on internal transfers) is the optimum transfer price if the supplying division is operating at full capacity.

–

🞂

This transfer price represents the opportunity cost for the transferring division.

However, if the supplying division has spare capacity, the optimum transfer price for decisionmaking is the variable production cost incurred by the transferring division.

–

This transfer price represents the incremental costs incurred if the transfer is made, as there is no opportunity cost.

This can be summarised as:

Optimum transfer price

No spare capacity in transferring division

Spare capacity in transferring division

Market value of the goods less any cost savings from internal transfers (that would be incurred on external sales).

Variable production cost of the goods.

We can see this demonstrated in the question below:

INTERACTIVE QUESTION 3: USING MARKET VALUE AS THE TRANSFER PRICE

[DIFFICULTY LEVEL: EASY]

Division A manufactures a component which is sold externally or transferred to Division B (which uses these components in its product).

Variable cost Transfer price at market value Fixed costs Profit Transfer price/selling price

Division A £ per unit 10 – 5 5 20

Division B £ per unit 15 20 10 25 70

Division A can sell externally at £20 per unit or transfer internally to Division B at £20 per unit.

Division B receives an offer from a customer of £30 per unit for its final product.

Requirement Question (a)

Answer

Would Division B accept the offer of £30 per unit given the existing transfer price?

(b) Is this the correct decision from the company’s point of view if: (i)

Division A has surplus capacity?

(ii)

Division A is operating at full capacity?

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Question (c)

Answer

What is the optimum transfer price if: (i)

Division A has surplus capacity?

(ii)

Division A is operating at full capacity?

4.3.2 A cost-plus approach to transfer pricing This transfer pricing method works in the same way as cost-plus pricing, discussed earlier in this chapter. 🞂

The transferring division determines the transfer price by adding a profit mark-up to the cost of the product or service.

🞂

Some form of cost-based transfer pricing method will usually be necessary where there is no external market for the product or service.

🞂

However, a number of issues arise with this transfer pricing method: –

A pre-determined standard cost should be used rather than actual cost. If standard costs are not used, then all efficiencies and inefficiencies are transferred from one division to another and divisional profit measurement is distorted.

–

To ensure that overheads are recovered, the supplying division will wish to base the transfer price on total cost. However, the supplying division’s fixed costs will then be perceived as variable costs from the point of view of the receiving division. This could lead to sub-optimal decisions.

WORKED EXAMPLE: SUB-OPTIMAL DECISION MAKING A company has two divisions, S and R. Both divisions manufacture multiple products. Division S transfers its output of component C to division R at full cost plus 10%. Division R then incurs further costs to convert component C into finished product P for sale on the external market at £40 per unit.

Costs incurred are as follows.

Variable cost Fixed cost absorbed Full cost

Division S £ per unit 20 10 30

Requirements Would the transfers be recommended from the point of view of: (a) (b)

The company as a whole?

The manager of division R?

Division R £ per unit 15

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SOLUTION (a)

The transfers would be recommended from the point of view of the company as a whole.

The variable cost incurred by the company as a whole for each unit of product P is £35.

Variable cost

– Division S – Division R

£ per unit 20 15 35

The fixed costs are irrelevant to this analysis because they would be incurred even if the transfers are not made.

Therefore from the point of view of the company as a whole the transfers are worthwhile because product P earns a contribution of £5 per unit (£40 – £35). (b)

The transfers would not be recommended from the point of view of the manager of division R. Transfer price per unit of component C = £30 + 10% = £33 The manager of division R would view the transfer price of component C as a variable cost, since it is an additional cost incurred by division R for every unit of product P manufactured.

Therefore, from the point of view of the manager of division R the variable cost of each unit of product P is £48.

Variable cost → component C (perceived variable cost) Additional cost incurred

£ per unit 33 15 48

Division R would not recommend the transfer of component C and the manufacture of product P since the division would record a negative contribution of £8 for each unit manufactured.

External market price Division R perceived variable cost Contribution

🞂

£ per unit of P 40 (48) (8)

In this example the use of a full cost-plus transfer price has led to sub-optimal decision making. There Is a lack of goal congruence because the manager of division R, in pursuing the division’s own goals, was not at the same time automatically pursuing the goals of the company as a whole.

Make vs. buy decisions When cost-plus transfer pricing systems are used, we also commonly see the receiving divisions considering external alternatives to purchasing components internally from other divisions (as they feel they are being charged too much). 🞂

For example, in the below diagram, if Division Beta feels it is being charged too high a transfer price by division Alpha, it may seek to buy in components from a third-party manufacturer.

🞂

This could lead to non-goal congruent decision-making in certain situations

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Transfer price Division Alpha

Division Beta LecFone

Component X Component X

External customers

Component X substitute

External customers

External supplier

As before, when making a decision on buying in components from external suppliers: 🞂

Division managers will take decisions that increase the contribution of their division.

🞂

A goal congruent decision for the company is one that increases the contribution of the whole company.

The decision-making approach from the whole-company’s point-of-view can be summarised as follows: Buy-in from external supplier?

No spare capacity in transferring division Spare capacity in transferring division

Yes

Buy-in price < revenue from transferring centre selling externally (their opportunity cost)

Buy-in price < variable cost of production for transferring division

No

Buy-in price > revenue from transferring centre selling externally

Buy-in price > variable cost of production for transferring division

INTERACTIVE QUESTION 4: MAKE VS. BUY DECISIONS

[DIFFICULTY LEVEL: INTERMEDIATE]

Division A manufactures a component which is sold externally or transferred to Division B (which uses these components in its product).

Variable cost Transfer price at market value Fixed costs Profit Transfer price/selling price

Division A £ per unit 10 – 5 5 20

Division B £ per unit 15 20 10 25 70

Division A can sell externally at £20 per unit or transfer internally to Division B at £20 per unit.

Division B receives an offer from a supplier to supply an alternative component for £15 per unit.

Requirements Will the manager of division B accept the offer and will that be a goal-congruent decision for the company if: (a)

Division A has spare capacity

(b)

Division A has no spare capacity

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SOLUTION Will the manager of division B accept the offer? (a)

Will this be a goal-congruent decision for the company?

Division A has spare capacity

(b) Division A has no spare capacity

4.3.3 Two-part transfer price To avoid the sub-optimal decisions that may occur when the fixed costs of one division are perceived as variable costs by another division, a two-part transfer price might be used. 🞂

Transfers are charged at a predetermined standard variable cost throughout the period.

🞂

A periodic charge for fixed costs would also be made by the supplying division to the receiving division. This has the effect of increasing the supplying division’s profit and reduces the receiving division’s profit.

🞂

This helps to ensure goal congruence, since the receiving division would be fully aware of the cost behaviour patterns of the company as a whole.

4.3.4 Dual pricing In dual pricing the supplying division is credited with a different price from that which is charged to the receiving division. 🞂

This transfer pricing method charges the receiving division for all transfers at variable or marginal cost. This may lead to improved decision making.

🞂

The supplying division is credited with the market value or with a cost-plus transfer price in order to provide a profit incentive to make the transfer.

🞂

The dual pricing method can be effective in avoiding sub-optimal decisions but it can be administratively cumbersome.

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Do you know the main criticism of full cost-plus pricing?

Do you know the advantages and disadvantages of using marginal cost-plus pricing?

Do you know the difference between mark-up and margin?

Can you list the practical methods of transfer pricing?

Yes/No

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6 Budgeting

Topic List 1

Why do organisations prepare budgets?

2

A framework for budgeting

3

Steps in the preparation of a budget

4

The master budget

5

Preparing forecasts

6

Alternative approaches to budgeting

7

Beyond budgeting

8

Big data, data analytics and data mining

9

Machine learning

10

Data bias and professional scepticism

Learning objectives 🞂

Apply forecasting techniques to help management in performance measurement and planning

🞂

Identify how data analytics can be used in budgeting and forecasting

🞂

Prepare budgets, or budget extracts from information supplied

🞂

Select the most appropriate of the following budgeting approaches and methods, taking into account their advantages and disadvantages for planning, control and motivation: – – –

bottom-up and top-down approaches to generating and managing budgets activity-based, responsibility-based and product-based structures zero-based and incremental budgeting

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1 Why do organisations prepare budgets?

As we will see in this chapter, budgeting involves looking ahead to a future period and estimating an organisation’s use of resources, profits, cashflows and financial position.

The act of preparing a budget has many advantages: 🞂

Budgeting forces management to look ahead and plan how to achieve targets.

🞂

Budgeting necessitates the communication of ideas and plans to staff.

🞂

Budgeting necessitates coordination and cooperation among teams (e.g. procurement and production teams).

🞂

Budgeting forces management to determine how much resource is needed for the coming period (cash, staff etc.) and to consider the best way to allocate their resources ahead of time and to (reducing the chance of unforeseen resource shortages).

🞂

Budgeting necessitates some delegation of authority (e.g. to incur expenditure) to staff at lower levels, which should both motivate employees and enable more efficient operation of the business.

🞂

Budgeting provides a framework for responsibility accounting (making staff responsible for specific budget targets).

🞂

Budgeting facilitates a system of control, with teams and employee performance vs. targets analysed via variance analysis (see chapter 9)

🞂

The act of setting targets and monitoring performance vs. targets can be motivational for employees (as long as those targets are achievable and within the control of the staff).

1.1 Budgets compared with forecasts Term

Definition

Forecast

A prediction of what is likely to happen in the future, given a certain set of circumstances.

Budget

A quantified plan of what the organisation intends should happen in the future

2 A framework for budgeting As we will see later in this chapter, the production of a budget for a future period will require the involvement of multiple different teams, the collation of financial and non-financial data and challenge / approval by managers / directors.

Hence, clear rules and structures are needed in order to produce an accurate, realistic and useful budget: Term

Definition

Budget committee

The budget committee is the coordinating body in the preparation and administration of budgets. The budget committee is usually headed up by the managing director (as chairman) who is assisted by a budget officer.

Budget period

The budget period is the period covered by the budget, which is usually one year (divided into months or quarters). However, budgets can be prepared and used for longer periods, for example capital expenditure budgets.

Budget manual

The budget manual is a collection of instructions governing the responsibilities of persons and the objectives and rules relating to the preparation and use of budgetary data.

Management Infor mation

6: Budge tin g

3 Steps in the preparation of a budget 3.1 Identifying the principal budget factor (PBF) The budget for the principal budget factor must be prepared first: 🞂

The principal budget factor is that factor which limits an organisation’s activities (usually sales demand).

🞂

A company will usually not want to create many more units of its product than it can sell → hence we must estimate the sale demand before we can consider the other functional budgets.

3.2 Functional budgets Per the diagram below, after determining the PBF, several functional budgets must be produced in a set order – key functional budgets are outlined below: Budget

Description

Sales budget

Budgeted sales volumes (in units) will be forecast using e.g. time series analysis. This is then turned into revenue by multiplying volumes by expected sales price per unit.

At the same time, the desired levels of finished goods inventories at the end of each month/quarter can be determined.

Production budget

This determines the expected number of units of product the organisation will need to produce to satisfy sales demand and expected inventory increases.

Hence, this can only be prepared once the sales and closing inventory budgets have been produced.

The units to produce will be calculated as follows: Sales units (from sales budget) Add: Closing inventory of finished goods Less: Opening inventory of finished goods Budgeted production of completed units Expected wastage* Budgeted total production*

X X (X) X X X

*Note: if expected wastage is W% (e.g. due to products failing quality control checks), budgeted total prod. = Budgeted prod. of completed units × 100/(100-W) Raw materials usage & purchases budgets

The raw materials usage budget can only be prepared once the production budget and standard quantities of materials per unit have been set.

The raw materials purchases budget then uses the usage budget and the raw materials inventory budget to determine the quantity and cost of raw materials to be purchased: Raw materials usage (units produced × materials per unit) Expected wastage of input materials* Total raw materials used in production* Add: Closing inventory of raw materials Less: Opening inventory of raw materials Raw materials to purchase

X X X X (X) X

* if W% of raw materials input are wasted, the total raw materials used = Units produced × materials per unit × 100/(100-W) Labour budget

This also must be produced after the production budget and will involve multiplying the units to be produced by the expected labour hours per unit, before factoring in different grades of labour (and wage rates) and any idle time.

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Management Infor mation

Step 1

Sales budget (PBF)

Step 2

Production budget

Step 3 Raw materials

Step 4

Labour

Production overhead

Cost of sales budget

Selling and distribution cost budget

General and administration cost budget MASTER BUDGET

Step 5

Income Statement

Step 6

Cash budget

Step 7

Statement of Financial Position

INTERACTIVE QUESTION 1: THE ORDER OF BUDGET PREPARATION

Capital expenditure budget

[DIFFICULTY LEVEL: EASY]

For the following pairs of budgets use the table to identify, under normal circumstances, whether the first budget should be produced before or after the second or whether it does not matter. Tick one box for each row. Assume that sales demand is the principal budget factor.

Before Sales revenue; sales quantities Closing inventory of finished goods, production volume Materials usage; labour hours Materials usage; materials purchases

After

Doesn't matter

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WORKED EXAMPLE: PREPARING A MATERIALS PURCHASES BUDGET ECO Co manufactures two products, S and T, which use the same raw materials, D and E. One unit of S uses 3 litres of D and 4 kilograms of E. One unit of T uses 5 litres of D and 2 kilograms of E. A litre of D is expected to cost £3 and a kilogram of E £7.

Budgeted sales for 20X2 are 8,000 units of S and 6,000 units of T; finished goods in inventory at 1 January 20X2 are 1,500 units of S and 300 units of T, and the company plans to hold inventories of 600 units of each product at 31 December 20X8.

Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the company plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X8.

The warehouse and stores managers have suggested that a provision should be made for damages and deterioration of items held in store, as follows.

Product S : loss of 50 units Product T : loss of 100 units Material D : loss of 500 litres Material E : loss of 200 kilograms Requirement Prepare a material purchases budget for the year 20X8.

SOLUTION To calculate material purchases requirements it is first necessary to calculate the material usage requirements. That in turn depends on calculating the budgeted production volumes.

Production

Product S

Product T

Sales demand Inventory loss Closing inventory Less opening inventory

8,000 50 600 (1,500)

6,000 100 600 (300)

Production

7,150

6,400

Material Purchases

Material D

Material E

For production of S For production of T Inventory loss Closing inventory Less opening inventory

21,450 32,000 500 5,000 (6,000)

28,600 12,800 200 3,500 (2,800)

Budgeted purchases

52,950

42,300

£3

£7

£158,850

£296,100

Unit cost Purchase cost

The basic principles for the preparation of each functional budget are similar to those above. Work carefully through the following question, which covers the preparation of a number of different types of functional budget.

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INTERACTIVE QUESTION 2: PREPARING FUNCTIONAL BUDGETS

[DIFFICULTY LEVEL: INTERMEDIATE]

XYZ company produces two products, X and Z. For the coming accounting period budgets are to be prepared based on the following information.

Budgeted sales Product X 2,000 at £100 each Product Z 3,000 at £150 each Budgeted usage of raw material Product X Product Z Cost per unit of material

RM11 5 2 £5

RM22 2 1 £3

Product X 500 750

Product Z 700 850

Finished inventory budget Opening Closing

Note: 10% of all production is usually scrapped (due to failing quality control checks) Raw materials inventory budget Opening Closing

RM11 21,000 18,000

RM22 10,000 9,000

Expected hours per unit Expected hourly rate (labour)

Product X 4 £9

Product Z 8 £9

Prepare: (a) Sales budget (b) Production budget (c) Material usage budget (d) Material purchases budget (e) Labour budget SOLUTION

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4 The Master Budget 4.1 The content of the master budget The master budget provides a consolidation of all the subsidiary budgets and normally comprises a budgeted income statement, a budgeted balance sheet and a cash budget.

WORKED EXAMPLE: PREPARING A MASTER BUDGET A new business is to be started and details of budgeted transactions are as follows. 🞂

Non-current assets will be purchased for £12,000. Depreciation will be charged on a straightline basis, assuming that the assets will have a useful life of five years after which they will have no residual value.

🞂

Month-end inventories will be maintained at a level sufficient to meet the forecast sales for the following month.

🞂

Forecast monthly sales are £4,000 for January to March, £5,000 for April to June and £6,000 per month for July onwards.

🞂

The gross profit margin is budgeted to be 20% of sales value.

🞂

Two months’ credit will be allowed to customers and one month’s credit will be received from suppliers of inventory.

🞂

Operating expenses (excluding depreciation) are budgeted to be £350 each month.

🞂

The budgeted closing cash balance as at 30 June is £16,700.

Requirement Use the above information to prepare a budgeted income statement for the six months ended 30 June and a budgeted balance sheet at that date.

SOLUTION Budgeted income statement for six months ended 30 June Revenue ((£4,000 × 3) + (£5,000 × 3)) Cost of sales (£27,000 × 80/100) Gross profit Operating expenses (£350 × 6) Depreciation ((£12,000/5) × 6/12) Budgeted profit

£ 27,000 21,600 5,400 2,100 1,200 2,100

Budgeted balance sheet as at 30 June Non-current assets (£12,000 – £1,200 depreciation) Current assets Inventories (July cost of sales = £6,000 × 80/100) Receivables (May and June sales) Cash

Current liabilities Net current assets Owners capital

£ 10,800 4,800 10,000 16,700 31,500 4,800 26,700 37,500 37,500

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5 Preparing forecasts 5.1 Historical data and linear relationships If we presume that events of the past can provide guidance for the future, we can attempt to use past data to forecast sales volumes or costs for future periods. 🞂

🞂

In this chapter we will use the following techniques, which assume a linear (straight line) relationship between variables (a simplifying assumption): –

The high-low method

–

Linear regression

A linear relationship between variables can be expressed using the equation y = a + bx, where: –

y is a dependent variable (e.g. total cost), whose value is determined based on the value of the independent variable (x)

–

x is an independent variable (e.g. units produced), whose value determines the value of y (the dependent variable).

–

a and b are constants (which we must find using either high-low or linear regression).

5.2 The high-low method The high-low method is a technique for analysing the fixed and variable cost elements of a semivariable cost and thus predicting the cost to be incurred at any activity level within the relevant range. 🞂

🞂

It assumes that the total cost and activity level (e.g. units produced) have a linear relationship of the form: Total Cost = F + V x Activity Level, where: –

F is the fixed cost

–

V is the variable cost per unit

Hence, we need to determine the values of F and V using the following steps: (i)

Find the total cost for the past periods with the highest and lowest activity levels – say: CH = the total cost at the highest activity level UH = the units produced at the highest activity level CL = the total cost at the lowest activity level UL = the units produced at the lowest activity level

(ii)

We can find the value of V (the variable cost per unit) as the difference in costs divided by the difference in units produced: C -C

V= H L

UH-UL

(iii)

We can then find the fixed cost F by substituting the value for V into the equation for either the high point or the low point.

(iv)

We can then forecast the total cost at any other activity level using the formula: Total Cost = F + V × Activity Level

🞂

Note that the high low method has the following disadvantages: –

It assumes a linear relationship between total cost and activity level.

–

It ignores all data points other than the highest and the lowest activity levels (which may not be representative of the population as a whole).

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INTERACTIVE QUESTION 3: HIGH LOW

[DIFFICULTY LEVEL: INTERMEDIATE]

The costs of operating the maintenance department of a computer manufacturer, Bread and Butter Ltd, for the last four months have been as follows.

Month

Cost £ 110,000 115,000 111,000 97,000

1 2 3 4

Production volume Units 7,000 8,000 7,700 6,000

Requirement Calculate the costs that should be expected in month 5 when output is expected to be 7,500 units.

Ignore inflation.

SOLUTION

5.3 Linear regression analysis Linear regression analysis is another statistical technique for establishing a straight-line equation to link a dependent and independent variable.

However, linear regression analysis is superior to the high-low method because it determines the straight-line relationship that best fits all sets of recorded data, rather than only those at the highest and lowest activity levels.

5.4 Correlation Correlation is the degree to which one variable is related to another, i.e. the degree of interdependence between the variables.

In the scatter diagrams below, you should agree that the straight-line equation is more likely to reflect the ‘real’ relationship between X and Y in (b) than in (a): 🞂

In (b), the pairs of data are all close to the line of best fit, whereas in (a), there is much more scatter around the line.

🞂

In the situation represented in diagram (b), forecasting the value of Y from a given value for X would be more likely to be accurate than in the situation represented in (a). This is because there would be greater correlation between X and Y in (b) than in (a).

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(a)

(b)

Y

Y

X

X

5.5 Measures of correlation 🞂

Two variables might be perfectly correlated, partly correlated, uncorrelated or subject to nonlinear correlation.

🞂

The more correlated two variables are, the more closely the data points in the population will fit onto a straight line.

🞂

Correlation, whether perfect or partial, can be positive or negative. 🞂

Positive correlation is the type of correlation whereby as one variable increases in value, so does the other.

🞂

Negative correlation is the type of correlation whereby as one variable increases in value, the other decreases in value.

5.5.1 The coefficient of correlation, r The degree of correlation between two variables is measured using the coefficient of correlation r. 🞂

🞂

r has a value between: –

–1 (perfect negative correlation) and

–

+1 (perfect positive correlation)

If r = 0 then the variables are uncorrelated.

5.5.2 The coefficient of determination, r2 The coefficient of determination, r2, is a measure of the proportion of the change in one variable that can be explained by variations in the value of the other variable.

5.5.3 Correlation vs causation It is important to remember that correlation does not necessarily mean that a cause-and-effect relationship exists. 🞂

A cause-and-effect relationship (also known as a causal relationship) exists between two variables when a change in one causes the change in the other.

🞂

Take the exam of sun cream and ice cream: –

When the sales of sun cream increase, the sales of ice cream also increase (correlation).

–

However, the increase in sun cream sales is not causing the increase in ice cream sales.

There is a third variable, namely the weather, influencing both types of sales.

–

This variable is known as a confounding variable.

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Perfect positive correlation (r=1)

Perfect negative correlation (r=-1)

Y

Y

X

X

Partial positive correlation (r=0.5)

Partial negative correlation (r=-0.5)

Y

Y

X

X

5.6 Time Series Analysis A time series (TS) is simply a set of data observed over a period of time. For example, sales patterns by month over several years.

A time series forecast identifies four components from a series of past figures recorded over time and then uses them to forecast the future. These components are: Component

Description

Trend (T)

The underlying long-term movement over time in historic data. This can be determined by a process of moving averages. For example, there may have been a general upward trend in house prices over the last five years.

Seasonal Variation (S)

Short-term periodic fluctuations in historic values. This can be determined by using either the additive or the proportional models (see later). For example, ice cream sales are higher in summer than in winter.

Cyclical Variation (C)

Longer-term fluctuations caused by such factors as economic activity / cycles.

Random Variation (R)

unpredictable fluctuations such as an act of nature.

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300

Quarterly sales revenue

250

£'000

200 150 100

Seasonal variation

50

Trend line

0 Yr 1 Q1 Yr 1 Q2 Yr 1 Q3 Yr 1 Q4 Yr 2 Q1 Yr 2 Q2 Yr 2 Q3 Yr 2 Q4 Yr 3 Q1 Yr 3 Q2 Yr 3 Q3 Yr 3 Q4

5.6.1 Finding the trend using moving averages Moving averages are used to strip any seasonal variations out of a data set in order to find the longterm trend. 🞂

E.g. if a company sees quarterly trends (higher than average sales in Q3, lower than average sales in Q4), taking an average of four quarters would eliminate those variations.

🞂

The average is then moved on to include one new period and remove one prior period (such that we are always including the same number of periods in the average calculation.

🞂

We can then review the moving averages which have been calculated in order to determine the trend.

WORKED EXAMPLE: FINDING THE TREND BY MOVING AVERAGES A business has recorded the following sales volumes over the last 6 months Month July August September October November December

Sales volume (units) 520 430 730 940 1240 1030

Requirement Calculate the three-month moving average for the period July to December SOLUTION Month

Sales volume (units)

Moving total 3 months

Moving average (/3)

July

520

August

430

520 + 430 + 730 = 1680

560

September

730

430 + 730 + 940 = 2,100

700

October

940

730 + 940 + 1,240 = 2,910

970

November

1240

940 + 1,240 + 1,030 = 3,210

1070

December

1030

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5.6.2 Incorporating seasonal variations to produce a forecast Having found the long-term trend, we now need to quantify the seasonal variations in order to forecast the expected results for future periods.

There are two models that we can use to determine the forecast time series: (a)

The additive model - used where we assume that the season variations for each period will be constant and can be simply added in absolute terms to the trend line to produce the forecasted result for the time series. This can be represented as: 𝑇𝑆 = 𝑇 + 𝑆 –

TS = time series forecasted result

–

T = long-term trend

–

S = seasonal variation adjustment

INTERACTIVE QUESTION 4: ADDITIVE MODEL

[DIFFICULTY LEVEL: EASY]

The trend equation for forecasting sales (A) for quarter (B) is 𝐴 = 12.2 + 1.3𝐵 Quarter 3 has a seasonal adjustment factor of +1.6 using the additive model. What is the time series forecast for Q3?

(b)

The multiplicative (or proportional) model – used where the seasonal variations for each period are in proportion to the value of the trend (and hence are quoted as a % of the trend value). This can be represented as: 𝑇𝑆 = 𝑇 × 𝑆

INTERACTIVE QUESTION 5: MULTIPLICATIVE MODEL

[DIFFICULTY LEVEL: EASY]

Forecast sales for the next quarter are £200,000 and the seasonal variation is 0.76. Using the multiplicative model, what is the underlying trend? 𝑇𝑆 = 𝑇 × 𝑆

Note: in the above example the season variation could also have been represented as -24% 🞂

The additive model assumes that the seasonal variations are independent of the trend

🞂

The multiplicative model assumes the seasonal variations are linked to the size of the trend.

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5.6.3 Advantages of time series analysis 🞂

Forecasts will be based on identified patterns in historic data

🞂

The trend line can be continually updated after each future period occurs, enabling accuracy of predictions to be assessed and then improved upon for future forecasts

5.6.4 Disadvantages of time series analysis 🞂

It assumes the historic trends and the seasonal variations will continue into the future

🞂

It becomes less reliable if you go outside the ranges of existing observations

🞂

It assumes that a straight line trend exists

6 Alternate approaches to budgeting There are several different approaches that an organisation can take to budgeting – we explore some of these approaches and their pros and cons below: Approach

Description

Pros / Cons

Incremental budgets

A system whereby the budget for the forthcoming period is calculated by taking the current budget or actual results and adjusting for changes such as anticipated inflation and growth.

Pros 🞂 🞂 🞂

Budget is stable and change is gradual Managers can operate their departments on a consistent basis System is relatively simple and quick to operate and coordinate and is easy to understand

Cons 🞂

Assumes activities and methods of working will continue in the same way 🞂 Encourages spending up to the budget, so that the budget is maintained next year 🞂 Budget may become out of date and no longer relate to the level of activity or type of work being carried out 🞂 There may be budgetary slack built into the budget, which then perpetuates into future budgets Rolling budgets This is a budget which, having been established at the beginning of a period, is then periodically amended and extended.

E.g. you produce the budget for the year-ended 31st December in year 1. At the end of March in year 1 you would then remove the first three months of the budget, update the budget for April-December year 1 and extend it to cover January – March year 2.

Pros 🞂 🞂 🞂

Provides better information for control and decision-making purposes in times of change Managers will always have access to an up-to-date budget.

Encourages staff to be continually looking at changing internal and external variables

Cons 🞂 🞂 🞂

Involves much time and effort Concept is not as readily understood by managers within an organisation Continually changing the goalposts can lead to de-motivation

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Approach

Description

Pros / Cons

Zero-based budgets

This is a budget that requires managers to justify every item of expenditure even if that item had been accepted in previous periods.

Pros 🞂 Results in efficient allocation of resources as based on needs and benefits 🞂

Identifies and eliminate wastage and obsolete operations

Cons

Bottom-up budgeting (participative)

Top-down budgeting (imposed)

The budget is produced by starting with the individual personal and departmental objectives set by the local management and then working up through the different levels of the organisation, setting appropriate targets to ensure the lower-level objectives are achieved.

🞂

Very time-consuming and difficult to coordinate

🞂

Training required for staff

🞂

Difficult to administer and communicate because more managers are involved in the process

Pros 🞂

Budgets are set by those closer to the detail so should be more informed and realistic

🞂

Greater staff participation leads to greater commitment and motivation

🞂

Takes up less senior management time

🞂

Encourages communication between departments

Cons 🞂

More scope for non-goal-congruent behaviour, budgets fitting local objectives rather than corporate goals (i.e. dysfunctional)

🞂

Lack of overall coherence

🞂

More time consuming and costly

🞂

Budgetary slack may be built in

🞂

Budgets may be inaccurate if less experienced managers are in place

The budget is set by starting with the overall corporate objectives set by the senior management and then working down through the different levels of the organisation, setting appropriate targets to ensure the higher objectives are achieved. 🞂 The pros / cons are the opposite of those for bottom-up budgeting

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7 Beyond Budgeting The Beyond Budgeting Round Table suggests that the traditional ways that businesses prepare budgets should be abandoned. It suggests that budgets should be more adaptive and agile and that this can be achieved using its 12 Beyond Budgeting principles: Leadership principles

Management processes

Purpose – Engage and inspire people around bold and noble causes; not around short-term financial targets

Rhythm – Organise management processes dynamically around rhythms and events; not around the calendar year only

Values – Govern through shared values and sound judgement; not through detailed rules and regulations

Targets – Set directional, ambitious and relative goals; avoid fixed and cascaded targets

Transparency – Make information open for selfregulation, innovation, learning and control; don't restrict it

Plans and forecasts – Make planning and forecasting lean and unbiased processes; not rigid and political exercises

Organisation – Cultivate a strong sense of belonging Resource allocation – Foster a cost-conscious mindand organise around accountable teams; avoid set and make resources available as needed; not hierarchical control and bureaucracy through detailed annual budget allocations Autonomy – Trust people with freedom to act; don't Performance evaluation – Evaluate performance punish everyone if someone should abuse it holistically and with peer feedback for learning and development; not based on measurement only and not for rewards only Customers – Connect everyone's work with customer needs; avoid conflicts of interest

Rewards – Reward shared success against competition; not against fixed performance contracts

🞂

These principles and processes may not be easy to implement without a major shift in a business' culture. However, some of the principles could be applied by using rolling budgets or zero-based budgets

🞂

Another criticism of traditional budgeting is that most businesses link employee benefits to the performance of the business against its budget and that this is unfair if the budgets are not very accurate. The rewards management process above is a useful solution.

8 Big data, data analytics and data mining 8.1 Key definitions Term

Definition

Big data

Large datasets (often relating to customers) collectable / accessible by organisations, whose analysis could provide key business insights.

Data analytics

Collecting, organising and analysing these large datasets to discover patterns and aid business decision-making.

Data mining

The act of sorting through data to identify patterns and relationships (turning raw data into information).

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8.2 Big data – what is it?

The main characteristics of big date are volume, velocity, variety and veracity.

Volume The scale of information which can now be created and stored is staggering. Even everyday items such as cars, video games and refrigerators can include sensors collecting consumer preferences and spending habits.

Velocity Timeliness is a key factor in the usefulness of financial information to decision makers. It is believed that users of Twitter generate nearly 100,000 tweets every 60 seconds!

Variety Big data consists of both structured and unstructured data and the challenge is to bring both together to reveal new insights.

Veracity It is also a challenge to keep information clean and free from bias. The source of the information can be a key consideration when judging the reliability of information.

8.3 Big data benefits Forecasting demand 🞂

Big Data from sources such as website traffic, online trends, customer feedback, promotions and microeconomic factors specific to the business's industry can be processed and an accurate model of future demand can be generated.

🞂

Such analysing uses data correlations alongside other known demand trends to predict customer demand responses to new products and marketing campaigns and this information can be fed into the sales forecast.

Identifying customer preferences 🞂

A key benefit of Big Data is the ability to understand the preferences and desires of each customer.

🞂

Consumers are increasingly happy to share information about themselves with a business, but only if they trust the organisation first.

🞂

Once this trust is built, data will come from the customer because they see the benefit of a more personal experience that is created.

🞂

This saves the customer time in finding what they want (because the website knows the products they are interested in) and more relevant promotions can be created.

8.4 Big data problems Lack of forecasting tools The sheer volume, complexity and speed of Big Data means that traditional forecasting tools cannot cope.

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Privacy 🞂

While Big Data can be a valuable 'asset' to a company, there are certain risks associated with Big Data. In addition to being beneficial for companies and customers, Big Data has the potential to harm individuals.

🞂

The link between online and offline identity and who should control our data is a key question. Big Data is borderless, but cultural attitudes towards privacy are very different across the world.

🞂

Concerns about whether or not governments are also gathering Big Data about individuals, including their own citizens, raises questions about the balance between the benefits and the infringement of rights.

Security 🞂

Companies using Big Data should ensure that they are not infringing the security of other organisations and their customers.

🞂

This also relates to people who are unaware of the security risks posed by their own actions, such as people who post their location on social media, revealing that they are on holiday, and are then targeted by robbers.

Incorrect data 🞂

If the data is incorrect then it is worthless and potentially harmful if incorrect conclusions are reached as a result.

Lack of skilled data analysts 🞂

Big Data requires data analysts and therefore a business needs to be able to recruit suitable employees to make full use of the data.

9 Machine Learning Machine learning is a field within AI whereby computers learn to do things rather than follow preprogrammed rules. 🞂

Through machine learning techniques, computers find patterns in data and use statistical models to classify or make predictions about other pieces of data.

🞂

There are different types of learning (eg supervised, unsupervised or reinforced) but all draw on large sets of training data that enable the computer to learn.

Enter what you want to know E.g. Forecast sales

Use results to make prediction better

Analyse the data and produce a prediction

Test the prediction against real results

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10 Data bias and professional scepticism 10.1 Professional scepticism Definition Professional scepticism: ‘Assessing information, estimates and explanations critically, with a questioning mind, and being alert to possible misstatements due to error or fraud.’ 🞂 There may be deliberate or accidental mistakes within information and professional scepticism means being aware of this and accepting that verification may be necessary. 🞂

This is particularly important for audit but is also important for management information. For example, if a colleague provides you with data and asks you to write a report about that data, you should want to verify that the data is correct, particularly if it came from the internet.

10.2 Data bias Definition Data bias: ‘Data is biased when it is not representative of the population. Data may be biased before its analysed just because the method of collecting the data means that some members of the population have a lower (or zero) chance of being included in the sample. People who analyse data and reach conclusions can also introduce bias.’ 🞂

There are several different types of bias and the following may impact on areas that you will see later in this course, such as budgeting, performance management and variance analysis.

Bias

Meaning and example

Selection bias

This occurs when the data is not selected randomly and leads to a sample that is not representative of the population. In order to be representative, all items in the population should have an equal chance of being selected for the sample.

Example – ease of selection Selection bias sometimes occurs because it is more convenient to select a certain group, for example, people in a particular geographic area.

Self-selection

This occurs when individuals select themselves.

Example – new product survey When customers choose whether to respond to a survey, those who choose to respond may have a certain characteristic or interest that leads them to respond. This creates a sample that is not representative of the whole population.

Observer bias

This occurs when observing and recording results and relates to interpretation → the researcher allows their assumptions (which may be unconscious) to influence their observations.

Example – unconscious bias Managers may be observing labour processes and draw conclusions based on their unconscious bias towards particular staff members.

Omitted variable

Omitted variable bias is when a variable is excluded from the data model and therefore the cause of a change in one variable is incorrectly attributed to another variable in the model.

Example – sales budgeting Sales of a product may depend on many variables such as advertising, price competition, fashion and cost of living. It would be easy to attribute an increase or decrease in sales volume to the wrong variable

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Bias

Meaning and example

Cognitive

This relates to human perception and includes bias depending on how data is presented (eg, infographics or the order of presentation, known as the ‘framing effect’) and ‘anchoring’ (eg, being influenced by the first piece of information offered or ‘stuck’ on last year’s numbers).

Example – budgeting Budgeting based on last year’s figures is very common but may lead to poor decision making and underachievement. Opportunities may be missed. This can be overcome by using zero-based budgeting or by considering what the budget might be if last year’s figures were unknown, ie, considering market size, growth, competition etc.

Confirmation

This occurs when people see data that confirms their beliefs, and they ignore (consciously or sub-consciously) data that disagrees with their beliefs.

Example – new product/market research Managers may have an idea for a new product and then ask for market research to confirm the viability of the idea. If market research is being performed to assess the popularity of a new product that the company has spent a lot of time and money developing, there may be pressure on the market research department to conclude that the product is not likely to fail.

Survivorship

This is the tendency towards studying successful outcomes while excluding unsuccessful outcomes. Only items that survived some previous event are included in the sample.

Example – performance management An accounting firm might decide to do a survey to find out how good its programme for trainee accountants is, by surveying a sample of trainees who have worked for the firm for one year. Such a survey would exclude trainees who left the firm before the end of the first year, who were presumably not very happy with the programme.

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you summarise the reasons for preparing budgets and the principles of beyond budgeting?

Can you list the functional budgets?

Do you know what the master budget is?

Do you know the main characteristics of big data?

Can you describe incremental budgeting, participative budgeting, imposed budgeting, ZBB and rolling budgets?

Yes/No

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7 Working capital

Topic List 1

What is working capital?

2

Balancing liquidity and profitability

3

Assessing the liquidity position via ratios

4

The cash operating cycle

5

Managing inventory

6

Managing trade payables

7

Managing trade receivables

8

Treasury management

9

Cash budgets

Learning objectives 🞂

Identify the constituent elements of working capital and treasury

🞂

Specify the methods by which each element can be managed by the finance function to optimise working capital and cash flow

🞂

Prepare a cash budget for a business, which highlights the quantity and timing of cash surpluses and budgets

🞂

Calculate the cash cycle for a business and recognise its significance

🞂

Recognise how a business manages surpluses and deficits predicted in cash budgets

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1 What is ‘working capital‘?

The net working capital investment of a business is made up of current assets less current liabilities: Receivables + Inventory +/- Cash – Payables 🞂

It is in effect the amount of cash required to ‘oil the wheels’ of business or to keep it running.

🞂

The management of working capital is concerned with:

🞂

–

The liquidity position of the company (the ability of the company to easily access resources such as cash and inventory)

–

The profitability of the company

We will see that companies must find a balance between liquidity and profitability (it’s a tradeoff).

2 Balancing liquidity and profitability When managing our investment in working capital, we must look at the four elements of working capital and consider the conflicting objectives of profitability vs. liquidity:

Cash

Actions to improve liquidity

Actions to improve profitability

Hold a large cash balance

Reduce cash balances in order to invest in income generating assets

Receivables Offer reduced credit terms / early settlement discounts to customers to speed up cash inflows.

Offer extended credit terms to attract customers, don’t offer early settlement discounts (to protect profit).

Inventory

Hold sufficient levels of raw materials and finished goods inventory to meet production / customer demand.

Hold reduced levels of inventory to free up cash for investment in income generating assets.

Payables

Delay payment to retain cash in the business for longer.

Pay promptly to take advantage of early settlements discounts (reducing costs and increasing profits).

3 Assessing the liquidity position via ratios A secure liquidity position is desirable. The business’s liquidity position can be assessed either by ratios or via the cash operating cycle.

These can be compared with: 🞂

The same company in previous periods

🞂

Other companies in the same industry

3.1 Average inventory period This measure shows the average length of time that inventory is held for.

Average inventory period = 🞂

Average inventory Cost of sales

× 365 days

We can calculate separate ratios for the three types of inventory (raw materials, work in progress and finished goods).

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🞂

If calculating raw materials inventory period (and if you have the information available), you should use materials purchases as the denominator (rather than cost of sales, which includes non-materials production costs).

🞂

If the inventory is held for a shorter period, the costs of holding the stock will decrease. A similar insight is obtained by calculating the inventory turnover ratio – see below.

3.2 Rate of inventory turnover The rate of inventory turnover monitors how many times inventory turns over during the trading period.

Cost of sales Inventory turnover ratio = Average inventory

3.3 Receivables collection period This KPI monitors how long on average it takes for credit customers to pay.

Average receivables Sales revenue

Average collection period =

× 365 days

🞂

If you have the information available, it would be best to use credit sales as the denominator (as receivables only relate to credit sales).

🞂

The collection period can also be measured in months, in which case the ratio calculation would be multiplied by 12 instead of by 365.

3.4 Payables payment period This KPI monitors how long on average the company waits before paying its suppliers.

Average payables period = 🞂

Average payables Cost of sales

× 365 days

If you have the information available, it would be best to use purchases as the denominator (cost of sales will include costs that aren’t paid on credit terms, such as labour costs).

4 The Cash Operating Cycle 4.1 What is the cash operating cycle?

Raw materials purchased

Raw materials inventory held

Customer pays us

Sale made

Raw materials used in production

Finished goods held

Waiting for customer to pay

Waiting to pay supplier Cash operating cycle We pay the supplier

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The measurement of the cash operating cycle focuses on the length of time between an organisation paying out cash for its raw materials and other input costs and receiving the cash for goods or services supplied.

4.2 Calculating the length of the cash operating cycle Av raw mat inventory Annual usage

× 365 days

x

Work in progress holding period =

Av WIP inventory Cost of sales

× 365 days

x

Finished goods holding period =

Av FG inventory Cost of sales

× 365 days

x

Average collection period =

Average receivables Sales revenue

× 365 days

x

Average payable period =

Average payables Cost of sales

× 365 days

(x)

Raw material holding period =

Length of cycle

x

Note: Where averages cannot be calculated or are not available then period-end balances should be used.

INTERACTIVE QUESTION 1: CALCULATING THE CASH OPERATING CYCLE Newport Ltd has the following estimated figures for the coming year: Sales Average receivables Gross profit margin Average inventories Finished goods Work in progress Raw materials Average payables

£3,600,000 £306,000 25% on sales £200,000 £350,000 £150,000 £130,000

Inventory levels are constant.

Raw materials represent 60% of total production cost.

Requirement

Calculate the company’s cash operating cycle.

SOLUTION

[DIFFICULTY LEVEL: EASY]

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7: Working capital

4.3 Limitations of working capital performance measures The measures must be used with care, because: 🞂

the balance sheet values at a particular point in time may not be typical.

🞂

balances used for a seasonal business will not represent average levels, eg, summer holiday travel business.

🞂

such measures concern the past not the future.

Therefore, measures should not be considered in isolation. Trends and industry averages are important.

4.4 Overtrading If an organisation is illiquid, it will be unable to meet its liabilities and will fail. When a business is growing its profits will increase, but it will also require more capital to pay for the increased levels of working capital. 🞂

If this extra capital (additional funding for the business) is not raised in time, the business will become illiquid.

🞂

This situation is commonly referred to as ‘overtrading’ as the growth in trade is what necessitated the extra capital, which if not raised leads to the business failing.

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4.5 Assessing the liquidity position 4.5.1 Current ratio This ratio measures the ability to meet short-term liabilities from easily or quickly realisable current assets. It is calculated as follows.

Current ratio

Current assets Current liabilities

🞂

A higher value for the ratio indicates that the business is more liquid, however if a business has a very high ratio this may indicate that funds are tied up in current assets unnecessarily.

🞂

The most appropriate level for the current ratio will depend on the type of business.

4.5.2 Quick ratio It is common to calculate this ratio by excluding inventory from current assets. This gives a quick / acid-test ratio.

Quick ratio

Current assets – inventory Current liabilities

Reasons for doing so are: 🞂

Inventory is the most illiquid of current assets (difficult to sell for cash)

🞂

The amount of sale proceeds would be likely to be lower than the carrying value in the accounts – so it’s prudent to ignore this amount.

EXAM SMART It’s common in the MI exam to be given several bits of data pertaining to the cash operating cycle / liquidity of the business (profit, liquidity ratios etc.) and asked to work back to find an input (e.g. receivables / payables / inventory / cash). 🞂

It’s best to start by writing down the calculations for any ratios you’ve been given

🞂

Then identify any ratios where you know the result and all but one of the inputs – workto then find that input by re-arranging the equation and use that input in another ratio calculation.

🞂

See the example below for an exam-grade example of this:

INTERACTIVE QUESTION 2: WORKING CAPITAL RATIOS

[DIFFICULTY LEVEL: HARD]

Division S is a retail operation. Its year-end working capital comprises inventory valued at cost, trade receivables of £90,000, cash and trade payables. Its financial performance ratios include the following Gross profit margin Current ratio Receivables collection period Payables payment period Rate of inventory turnover

25% 2.3:1 30 days 40 days 18 times

The opening inventory, receivables and payables balances are the same as the closing balances.

Requirement Calculate the division’s year-end cash balance.

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7: Working capital

SOLUTION

5 Managing inventory 5.1 Costs associated with holding inventory As we discussed earlier, it is vital to hold sufficient inventory in order to meet production and customer demand (and reduce ordering costs), but holding too much inventory will reduce our profitability by exposing the business to increased holding costs.

Hence, we need to carefully manage our inventory levels and the associated costs: Cost type

Examples

Holding costs

Costs generated from holding the inventory (storage and insurance costs, risk of obsolescence of / damage to inventory) and the lost opportunity cost of not being able to invest the cash tied-up in the inventory.

Ordering costs

Costs incurred whenever an order is place (e.g. delivery charges).

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Cost type

Examples

Shortage costs

Costs incurred if we run out of raw materials / finished goods (such as lost sales, emergency order costs).

5.2 Inventory control systems For both finance and operational reasons it is therefore very important to control inventory levels effectively. There is a wide range of inventory control systems available.

System

Description

Re-order level system

A fixed quantity will be ordered whenever inventory falls to a predetermined level (the reorder level).

Periodic review system

Inventory levels are reviewed at fixed time intervals to fit in with production schedules, and variable quantities are ordered as appropriate.

ABC system

Inventory is categorised into classes A, B or C according to the annual cost of the usage of that inventory item, or the difficulty of replacements, or the importance to the production process. Class A will then take most of the inventory control effort, Class B less and Class C less still.

Just-in-Time system (JIT)

Production and purchasing are linked closely to sales demand on a week-to-week basis.

Goods should only be produced when they are needed, with raw materials only being ordered when production is needed (and negligible amounts of materials inventory held).

This requires flexible suppliers and workforce, guaranteed material quality and a close working relationship with and proximity to suppliers.

Perpetual inventory methods

Inventory records are updated for each receipt and issue of inventory as it occurs (allowing management to see inventory balances on an on-demand basis to improve control and decision-making).

6 Managing trade payables Credit periods for the buyer are a source of short-term finance. For example, if a buyer decides not to pay its trade debts for a further month, it has obtained a further month’s use of its cash.

Trade Payables are not, however, without cost 🞂

Suppliers may withdraw credit status if payments are not made on time

🞂

Delayed payment may lead to increased supplier prices or lost discounts

The advantages of trade credit are: 🞂

It is convenient and informal

🞂

Useful where businesses do not qualify for traditional credit sources (e.g. from lenders)

🞂

Can be used on a very short-term basis to overcome unexpected cash flow crises

6.1 Good payment practices Late payments to suppliers, particularly to small businesses, can have a significant impact on their cash flow, on whether they can invest and grow, and hence potentially on their survival.

Large businesses often force small businesses to accept unfair payment terms and many small businesses are loath to charge interest on overdue invoices. 🞂

Prompt payment falls under the ‘social’ and ‘governance’ facets of ESG (mentioned in Chapter 1) and is deemed vital for a thriving economy and long-term sustainability.

Management Infor mation

🞂

7: Working capital

Legal obligations to report payment practices and policies exist in some countries, while voluntary codes (such as the Prompt Payment Code in the UK) allow organisations to commit to good payment practices.

7 Managing trade receivables 7.1 What is the ideal level of trade receivables?

The management of trade receivables involves the business trading-off: 🞂

The costs of extending credit to customers – these include finance costs, irrecoverable debts and administrative costs of the credit control department.

🞂

The benefits of granting credit – in their simplest form these are larger profits due to the increased sales generated because of the credit terms offered.

7.2 Credit control and settlement discounts 7.2.1 Credit terms and settlement discounts Settlement discounts (discounts offered to customers for early settlement) are again influenced largely by custom and practice within the industry. 🞂

The business must ensure the cost does not outweigh the benefit, and should compare it with the cost of other sources of short-term finance, e.g. overdraft.

🞂

Offering discounts can be expensive. For example, if it costs a company a 2% discount to bring customer receipts forward by one month, the equivalent annual interest rate (assuming monthly compounding) would be 1.0212 – 1 = 26.8% (though this may be offset by increased sales to new customers attracted by the offer of discounts).

WORKED EXAMPLE: IMPACT OF EARLY SETTLEMENT DISCOUNTS Left Ltd has monthly sales of £20,000. 25% of receivables are paid within one month of a sale, and 70% are paid within two months, but 5% of receivables are never paid. Left Ltd proposes offering a 3% discount to receivables settling invoices within one month of the invoice date. As a result, monthly sales are predicted to rise to £25,000, and 50% of trade receivables will pay within one month. 44% will pay within two months but irrecoverable debts will rise to 6%. All sales are invoiced at the end of each month. The discount will be offered for all invoices issued from Month 1.

By how much will total cash inflows from trade receivables in Months 1 and 2 change as a result, and what will be the effect on profit?

Cash received Sales Month 1 Month 2 Bad debts Discount allowed Current policy Sales M1 Sales M2 Total cash Proposed policy Sales M1 Sales M2 Total cash

20,000 20,000

(25%) 5,000 5,000

25,000 25,000

(50% × 97%) 12,125 12,125

(70%) 14,000 5,000 19,000

(5%) 1,000 1,000

(44%) 11,000 12,125 23,125

(6%) 1,500 – 1,500

– – – (50% × 3%) 375 375

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There is a large cash flow benefit of £7,125 in Month 1, and a benefit of £4,125 per month once the normal pattern is established. The reduction in monthly profits caused by increased irrecoverable debts is £500, while profits are further reduced by £375 with respect to the discount allowed.

7.2.2 Credit ratings and good practice The risk that a customer will not pay its debts can be indicated by giving each customer a credit rating. 🞂

Credit ratings can be determined by the supplier by analysing financial statements of the customers or reviewing past trading experience against the customer.

🞂

They can also be determined with reference to external sources of information (such as credit rating agencies and trade / bank references).

🞂

Credit terms limits can then be set based on this information.

Companies can then follow best-practice steps to reduce the risks of late / non-payment: (1)

Raise invoices on time

(2)

Respond to customer queries promptly

(3)

Follow-up on overdue invoices promptly

(4)

Put accounts on stop if credit terms are exceeded or customers are serial late-payers

(5)

Regularly review credit terms and limits

7.3 Financing trade receivables Receivables are an asset, and so can be ‘sold’ like any other asset by means of invoice discounting or factoring (in order to bring cash into the business now).

7.3.1 Invoice discounting This involves selling the invoices to a discounting company for a cash sum (less than 100% of the face value of the receivable, then repaying the discounter when the debtor pays the invoice. 🞂

This is effectively the same as borrowing against the value of the receivable.

🞂

The supplier retains full responsibility for credit control and collection.

7.3.2 Receivables factoring A debt factor takes over the management of credit control function (collecting debts from customers on the supplier’s behalf). This contains three closely integrated elements: 🞂

Accounting and collection – the business is paid by the factor as customers settle their invoices or after an agreed settlement period. The factor maintains the sales ledger accounting function.

🞂

Credit control – the factor is responsible for chasing the customers and speeding up the collection of debts.

🞂

Finance against sales – the factor advances, say, 80% of the value immediately on invoicing.

7.4 Trade credit insurance Trade credit insurance insures a business against the possible default and insolvency of its credit customers and, where exports are involved, political risk. Businesses can: 🞂

Insure all or part of its receivables ledger against default by a customer

🞂

Include a ‘first loss’ (or excess) on its accounts to be insured

Management Infor mation

7: Working capital

🞂

Be insured only up to a ceiling (‘credit limit’)

🞂

The premium paid will vary in accordance with the above factors.

8 Treasury management 8.1 The basic trade-off: cost of holding v cost of running out of cash 🞂

The cost of holding cash includes the opportunity cost of what else could be done with the money (as cash is an idle asset and earns no return for the company).

🞂

The costs of running out of cash vary, depending upon the circumstances of the business, but could lead to the cessation of trade (if the business cannot pay staff, suppliers and its taxes).

8.2 Aim of good cash management The primary aim of good cash management is to have the right amount of cash available at the right time. This involves: 🞂

Accurate cash budgeting/forecasting

🞂

Planning short-term finance when necessary

🞂

Planning investment of surpluses when necessary

🞂

Cost-efficient cash transmission

8.3 Sources of short-term finance / options for investment Sources of short term finance

Options for investment

Receivables factoring

Treasury bills (issued by the Bank of England, min investment of £50,000, mature after 3 months, very liquid but low return).

Invoice discounting

Deposit accounts

Bank overdrafts (repayable on demand, but flexible and you only pay interest when overdrawn)

Gilts (longer-term government debt)

Short-term bank loans

Bonds (corporate debt – higher risk and higher returns than T-bills and gilts)

Operating leases (lease equipment instead of buying it to delay cash outflows)

Equities (risky and only liquid if the issuing company is listed)

9 Cash budgets 9.1 The need for cash budgets A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a way as to show the forecast cash balance of a business at defined intervals. 🞂

Cash budgets are vital in enabling management to make forward planning decisions (such as securing additional financing if a future cash deficit is forecast).

🞂

The further into the future that a cash budget extends, the sooner that management can address any issues it identifies.

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9.2 Preparing cash budgets In the MI exam you may be given detailed information about the timings of receipts from customers and the timings of payments to suppliers, enabling you to produce a cash budget, as we will see in the following example:

INTERACTIVE QUESTION 3: PREPARING A CASH BUDGET

[DIFFICULTY LEVEL: INTERMEDIATE]

Penny operates a retail business. Purchases are sold at cost plus 33 1/3%.

January February March April

Budgeted sales in month £ 40,000 60,000 160,000 120,000

Labour cost in month £ 3,000 3,000 5,000 4,000

Expenses incurred in month £ 4,000 6,000 7,000 7,000

🞂

It is management policy to have sufficient inventory in hand at the end of each month to meet half of next month’s sales demand.

🞂

Suppliers for materials and expenses are paid in the month after the purchases are made/expenses incurred. Labour is paid in full by the end of each month.

🞂

Expenses include a monthly depreciation charge of £2,000.

🞂

75% of sales are for cash.

🞂

25% of sales are on one month’s credit.

🞂

The company will buy equipment costing £18,000 for cash in February and will pay a dividend of £20,000 in March. The opening cash balance at 1 February is £1,000.

Requirement Prepare a cash budget for February and March and comment on the result.

SOLUTION

Management Infor mation

7: Working capital

9.3 Deriving cashflows from forecast Balance Sheet / Income Statement Alternatively, we may be given excerpts from the forecast income statement and forecast balance sheet (from the master budget) and be expected to derive forecast cash payments receipts: Calculating forecast cash receipts

Calculating forecast cash payments

Sales for the period

X

Purchases for the period

X

Opening receivables

X

Opening payables

X

Closing receivables

(X)

Closing payables

(X)

Cash received from customers

X

Cash paid to suppliers

X

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WORKED EXAMPLE: CASHFLOWS FROM THE BALANCE SHEET / INCOME STATEMENT Rocket plc has the following budgeted amounts for the year ended 31st December 20X7: Sales of £2.5m and purchases of £1.2m Opening trade receivables of £313,000 and closing trade receivables of £327,000 Opening trade payables of £100,000 and closing trade payables of £117,000 Requirement Calculate the forecast cash receipts from customers and cash payments to suppliers during 20X7 SOLUTION Calculating forecast cash receipts

Calculating forecast cash payments

Sales for the period

2,500,000

Purchases for the period

1,200,000

Opening receivables

313,000

Opening payables

100,000

Closing receivables

(327,000)

Closing payables

(117,000)

Cash received from customers

2,486,000

Cash paid to suppliers

1,183,000

9.4 Responses to different cash positions Short-term surplus 🞂 Pay suppliers early in return for settlement discount 🞂 Increase receivables and inventories 🞂 Invest short term

Short-term deficit 🞂 Increase payables by delaying payments to suppliers 🞂 Reduce receivables and inventories 🞂 Arrange overdraft

Long-term surplus 🞂 Invest long term 🞂 Expand / diversify 🞂 Replace non-current assets 🞂 Increase dividends / buy back shares

Long-term deficit 🞂 Raise long-term finance 🞂 Consider divestment 🞂 Consider selling non-current assets 🞂 Plan a controlled shutdown

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Do you know the formulae for the inventory, receivables, payables and liquidity ratios?

Do you know how to calculate the length of the cash operating cycle?

Can you explain receivables factoring?

Can you name some sources of short-term finance?

Yes/No

99

8 Performance management

Topic List 1

Performance evaluation

2

Responsibility centres

3

Performance measures for investment centres

4

The balanced scorecard

5

Budgetary control

6

Organisational efficiencies relative to performance management

7

Sustainability and ESG reporting

Learning objectives 🞂

Identify the reasons for and key features of effective performance management systems

🞂

Select appropriate financial and non-financial performance measures which effectively encourage the business as a whole to meet its objectives

🞂

Identify the features of cloud accounting and their associated risks and benefits

🞂

Identify the features of shared service centres and their relative merits for the provision of management information

🞂

Identify suitable metrics for ESG reporting

100 8: Perfo rmance management

Management Infor mation

1 Performance evaluation 1.1 Feedback control Feedback control describes the process whereby: (i)

Plans and targets are set for the future

(ii)

Plans are put into operation

(iii)

Actual results are recorded and analysed

(iv)

Actual results are fed back to management

(v)

Management compare actual results to the plan / targets

(vi)

Management can then take control action or alter the plan / targets INPUT RESOURCES

Plan, target or budget

Compare actual results with plan

Feedback of information

Control action

Measure outputs

OPERATIONS

OUTPUTS (eg actual output revenues, costs)

1.2 Features of effective feedback Reports should be clear and comprehensive

Reports should be made available in a timely fashion

Significant differences between actuals and targets should be the focus of investigation

Reports should be sufficiently accurate

Controllable costs / revenues should be separately identified

Irrelevant detail should be excluded

Reports should be provided on a regular basis

Reports should go to the manager who has responsibility and authority to act

1.3 The behavioural impact of performance measurement 🞂

Research evidence suggests that often performance measures lead to a lack of goal congruence.

Managers seek to improve their performance on the basis of the indicator used, even if this is not in the best interests of the organisation as a whole.

🞂

There are three distinct ways of using budgetary information to evaluate performance (Hopwood’s styles of evaluation).

Style of evaluation

Comment

Budget constrained

The manager’s performance is primarily evaluated upon the basis of his ability to continually meet the budget on a short-term basis i.e. did actual costs exceed the budgeted costs? (Regardless of other considerations)

Management Infor mation

8: Perfo rmance manageme nt

Style of evaluation

Comment

Profit conscious

The manager will be evaluated on the basis of his/her ability to generate profits overall. This will encourage a longer-term view by managers as they will be focussed not only on achieving immediate goals, but also longer-term goals.

Non-accounting

The budgetary information plays a relatively unimportant part in the superior’s evaluation of the manager’s performance

The effects of these styles are summarised below: Style of evaluation

Budget constrained

Profit conscious

Non-accounting

Involvement with costs

High

High

Low

Job-related tension

High

Medium

Medium

Manipulation of reports (bias)

Extensive

Little

Little

Relations with the supervisor

Poor

Good

Good

Relations with colleagues

Poor

Good

Good

2 Responsibility centres Divisionalisation and decentralisation of a business necessitate a robust responsibility accounting system (see chapter 1) in order to hold managers to account over the costs and revenues they control.

2.1 Divisionalisation This involves splitting the company into divisions, for example according to location or according to the product or service provided. Divisional managers are then given the authority to make decisions concerning the activities of their divisions.

2.2 Decentralisation Divisionalisation usually leads to decentralisation in the decision-making process. In a decentralised organisation divisional managers may have the freedom to set prices, choose suppliers, make output decision and so on.

2.2.1 Factors affecting the degree of decentralisation 🞂

Management style

🞂

The size of the organisation

🞂

The extent of activity diversification

🞂

Effectiveness of communications

🞂

The ability of management

🞂

The speed of technological advancement

🞂

The geography of locations and the extent of local knowledge needed

2.2.2 The advantages and disadvantages of decentralisation Advantages

Disadvantages

Senior managers are freed from detailed involvement in day-to-day operations

Coordination of activities can be difficult

Improvement in the quality of decisions (as decision-makers have better local knowledge)

There may be a lack of goal-congruence in decisionmaking

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Advantages

Disadvantages

It should be motivational for managers

Senior managers lose control over day-to-day activities

Decisions should be taken more quickly

Performance evaluation becomes more difficult (e.g., identification of controllable costs)

Junior managers will gain useful managerial skills and experience

There may be duplication of roles

2.3 Responsibility accounting Per chapter 1, responsibility accounting involves identification of e.g., the costs and revenues that a manager has control over for the purposes of performance appraisal.

The costs, revenues, assets and liabilities a manager has control over will be dependent on the type of centre / department the manager runs: Type of centre

Principle performance measures

Description

Manager has control over

Cost centre

Any part of an organisation that incurs costs.

Controllable costs

Cost variance analysis Efficiency measures

Revenue centre

A section of an organisation which creates revenue but has no responsibility for production.

Revenues only

Revenue variances Revenue per employee Revenue growth Market share

Profit centre

A section of an organisation that both creates revenue and incurs costs.

Controllable costs Sales prices (including transfer prices)

Profit Profit margins

Investment centre

A section of an organisation whose manager has some say in investment policy in their area, as well as being responsible for costs and revenues.

Controllable costs Sales prices (including transfer prices) Output volumes Investment in non-current assets and working capital

Return on investment Residual income Current / quick ratios Inventory turnover Receivables/payables periods

INTERACTIVE QUESTION 1: CONTROLLABLE INVESTMENT IN DIVISION

[DIFFICULTY LEVEL: EASY]

The manager of division D has complete autonomy regarding the purchase and use of non-current assets and inventory, but the payment of all suppliers is undertaken by head office which maintains a central bank account. The manager also has authority to establish the division’s own credit policy with regard to its customers. The division operates a credit control department, but all cash received from customers is remitted immediately to head office.

Classify (by deleting, as appropriate) the following assets and liabilities to indicate whether or not they are a part of the divisional investment that is within the control of the manager of division D. Part of controllable investment Non-current assets Trade receivables Trade payables Inventory

Not part of controllable investment

Management Infor mation

8: Perfo rmance manageme nt

3 Performance measures for investment centres As investment centre managers have responsibility for costs, revenues and the use of assets, we need investment measures that take all of these factors into account:

3.1 Return on investment (ROI) ROI is often used as a measure to monitor the performance of an investment centre. It shows how much profit has been earned in relation to the amount of capital invested in the centre.

ROI =

Controllable divisional profit Divisional capital employed

× 100

🞂

This gives a relative (%) measure of the return made by the division on its capital employed.

🞂

Careful consideration is needed as to the capital employed to include. Usually either opening capital employed or an average of opening and closing capital employed is used.

🞂

Centrally controlled assets should be excluded.

3.2 Residual income (RI) An alternative way of measuring the performance of an investment centre is residual income (RI). RI is a measure of the centre’s profits after deducting a notional or imputed interest cost of the capital invested in the centre.

Controllable divisional profit

x

Imputed interest cost of capital

(x)

Residual income

x

🞂

The cost of capital should represent the cost of the company’s funding (i.e. an interest rate).

🞂

RI can avoid some of the behavioural problems of dysfunctionality that arise with the use of ROI (as it shows performance in terms of £).

🞂

However, the illustration below shows a weakness of RI.

WORKED EXAMPLE: USING ROI AND RI TO MEASURE COMPARATIVE PERFORMANCE A company has a target ROI and an imputed interest charge of 20% for each of its investment centres.

Which of the two divisions is performing better, using the following performance measures? (a) (b)

Residual income Return on investment

Capital employed Controllable profits: Year 1 Year 2

Division 1 £1,000,000

Division 2 £100,000

£200,000 £220,000

£20,000 £40,000

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SOLUTION (a)

Residual income:

Year 1 Divisional profit Imputed interest charge (£1,000,000 × 20%) (£100,000 × 20%) RI Year 2 Divisional profit Imputed interest charge

(b)

Division 1 £’000

Division 2 £’000

200

20

200 –

20 –

220 200 20

40 20 20

🞂

Using RI the relative performance of the two divisions appears to be the same.

🞂

Both divisions have increased the annual RI by £20,000.

Return on investment: Division 1

Division 2

Year 1

£200,000/£1,000,000 = 20%

£20,000/£100,000 = 20%

Year 2

£220,000/£1,000,000 = 22%

£40,000/£100,000 = 40%

🞂

Return on investment shows that division 2 is outperforming division 1.

🞂

Despite earning the same absolute increase in RI it is much easier for the larger division to generate a further £20,000 of RI.

🞂

Hence using RI to compare divisions of different sizes is misleading.

INTERACTIVE QUESTION 2: ROI AND RI

[DIFFICULTY LEVEL: INTERMEDIATE]

An investment centre with capital employed of £570,000 is budgeted to earn a profit of £119,700 next year. A proposed non-current asset investment of £50,000, not included in the budget at present, will earn a profit next year of £8,500 after depreciation. The company’s cost of capital is 15%.

Calculate the budgeted ROI and RI for next year, both with and without the investment.

Management Infor mation

8: Perfo rmance manageme nt

3.3 ROI vs. RI Advantages of RI vs. ROI

Disadvantages of RI vs.ROI

Residual income will increase when investments earning above the cost of capital are undertaken (hence, as long as the return on a project beats the notional cost of capital it will be undertaken).

It does not facilitate comparisons between investment centres.

Residual income is more flexible since a different cost of capital can be it does not relate the size of a applied to riskier investments. centre’s income to the size of the investment.

4 The balanced scorecard 4.1 Introduction The balanced scorecard was developed to help companies manage the multiple objectives they must satisfy to compete in today’s markets. Traditional accounting measures have a number of weaknesses that make them less relevant today. 🞂

They tend to concentrate on a single factor, eg profit, revenue, ROI or RI

🞂

They are primarily historical, eg how have we done compared with last year

🞂

They are capable of distortion

🞂

There is often confusion between measures and objectives

🞂

Traditional accounting performance measures are of little use as a guide to action

4.2 The balanced scorecard approach The balanced scorecard involves the following steps: 🞂

Identify the critical success factors for the business from four perspectives: –

Financial perspective – how do we create value for our shareholders?

–

Customer perspective – what do new and existing customers value from us?

–

Innovation and learning perspective – can we continue to improve and create value?

–

Internal business perspective – at what must we excel?

🞂

Identify the core competences and resources required to achieve them

🞂

Develop the key performance indicators (financial and non-financial – see below) to best measure progress towards achieving the necessary competences and resources

🞂

Set targets

🞂

Monitor performance

4.3 Example Key Performance Indications (KPIs) Financial perspective 🞂 Sales growth 🞂 Profit margins 🞂 Return on investment 🞂 Working capital ratios

Customer perspective 🞂 Time (e.g. delivery times) 🞂 Quality (e.g. product defect rates) 🞂 Satisfaction (e.g. repeat purchases)

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106 8: Perfo rmance management Innovation and learning perspective 🞂 Revenue from new products 🞂 Staff turnover / satisfaction 🞂 Staff training / CPD

Management Infor mation

Internal business perspective 🞂 Efficiency (e.g. average production time / unit) 🞂 Quality control rejects 🞂 Material wastage rates

INTERACTIVE QUESTION 3: BALANCED SCORECARD EVALUATION

[DIFFICULTY LEVEL: INTERMEDIATE]

Jennings & Frazer are a firm of High Street solicitors. They have traditionally measured their success in terms of ROI. They have decided to modernise their approach and plan to use the Balanced Scorecard to measure performance. Suggest three measures they could use under each of the four balanced scorecard perspectives.

Financial perspective

Customer perspective

(1)

(1)

(2)

(2)

(3)

(3)

Innovation and learning perspective

Internal business perspective

(1)

(1)

(2)

(2)

(3)

(3)

5 Budgetary control In order to make a meaningful comparison of actual results to our expectations, we need to compare them to a budget that is based on the actual activity levels (i.e. the actual units sold) – a flexible (or ‘flexed’) budget.

5.1 Fixed budgets A fixed budget is one that is prepared for the expected level of production or output and then not adjusted for actual production or output.

5.2 Flexible budgets A flexible budget recognises different cost behaviour patterns and is designed to change as the volume of activity changes.

Management Infor mation

8: Perfo rmance manageme nt

5.2.1 Preparation of a flexible budget In order to prepare a flexible budget, we need to first identify the behaviour of the various cost lines in the budget (per chapter 1 – are they variable, fixed or semi-variable?). 🞂

You may be told the cost behaviour in the question.

🞂

If not (as in interactive question 4), we can determine the cost behaviour by observing what happens to the total cost and cost per unit as activity levels (the number of units produced / sold) increase: Variable costs

Fixed costs

Semi-variable costs

Behaviour of total cost as activity level increases

Increases

Remains constant

Increases

Behaviour of cost per unit as activity level increases

Remains constant

Reduces

Reduces

INTERACTIVE QUESTION 4: FLEXIBLE BUDGETS AND COST BEHAVIOUR [DIFFICULTY LEVEL: INTERMEDIATE] WL Co manufactures and sells a single product, R. Since the R is highly perishable, no inventories are held at any time. WL Co’s management uses a flexible budgeting system to control costs. Extracts from the flexible budget are as follows.

Output and sales (units) Budget cost allowances Direct material Labour Variable production overhead Fixed production overhead Selling and distribution overhead Administration overhead Total expenditure

4,000 £ 16,000 20,000 8,000 11,000 8,000 7,000 70,000

5,500 £ 22,000 24,500 11,000 11,000 9,500 7,000 85,000

Production and sales of product R amounted to 5,100 units during period 5.

The total budget cost allowances in the flexible budget for period 5 will be: (a)

Direct material

£

(b)

Direct labour

£

(c)

Variable production overhead

£

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(d)

Fixed production overhead

£

(e)

Selling and distribution overhead

£

(f)

Administration overhead

£

6 Organisational efficiencies relative to performance management 6.1 Shared service centres (SSC) Basic processing tasks are now often carried out in shared service centres. Shared service centres consolidate the transaction-processing activities of many operations within a company. Functions such as human resources, payroll, accounting and IT may be carried out in a shared service centre. The aim of a shared service centre is to achieve significant cost reductions while improving service levels through the use of standardised technology and processes and service level agreements.

Advantages to using a shared service centre

Disadvantages to using a shared service centre

🞂

🞂

🞂 🞂 🞂

reduced headcount due to economies of scale resulting from the single location associated reduction in premises and other overhead costs knowledge sharing should lead to an improvement in quality of the service allows standard approaches to be adopted across the organisation leading to more consistency

🞂

🞂

🞂

loss of business specific knowledge. For example, creating a consolidated finance function which broadly handles financial matters for the entire organisation may lack an understanding of specific finance issues affecting individual departments or business units. removed from decision making. An SSC finance function is unlikely to be able to provide meaningful financial information for decision making if finance personnel are removed from the day to day realities facing a particular department or business unit. weakened relationships. Geographical distance between the site of the SSC and the respective business areas it serves may weaken the relationships between the two. cost inefficiencies. Cost inefficiencies within the SSC could potentially be passed on to the client division and this is likely to lead to friction between the two parties.

Management Infor mation

8: Perfo rmance manageme nt

6.2 Cloud accounting 6.2.1 Definitions Cloud computing is the model enabling on demand access to application, storage, networks at anytime from anywhere online.

Cloud accounting is an application of cloud computing where accountancy software is provided in the cloud by a service provider.

Benefits of cloud accounting

Risks of cloud accounting

🞂

🞂

🞂 🞂 🞂 🞂

🞂 🞂

🞂

Accounting information can be accessed from anywhere, at any time, from a browser or mobile device, as long as internet access is available.

The security systems in place will often be better than a small business can provide.

The software updates are managed by the cloud accounting supplier.

Back-ups are made automatically by the cloud accounting supplier.

Applications are usually rented rather than purchased meaning that there are no upfront costs.

Overhead costs, such as in-house technical experts costs, can be reduced.

There is no need to worry about whether PCs are powerful enough as the software is running in the cloud, not on the PC. If the business grows then more cloud accounting licences can be purchased. There is no need to upgrade servers and so on.

🞂

🞂 🞂

🞂

The supplier could fail and so a contingency plan is required.

There is a permanent need for internet access.

Operations could be hampered if there is a problem with internet access.

There is a risk of security breaches, including data loss or theft and privacy issues.

There are legislation risks if the cloud supplier operates from a jurisdiction where the laws are different from the country in which the data is being used (particularly privacy laws).

Unannounced changes or upgrades to software could be disruptive.

7 Sustainability and ESG reporting 7.1 Monitoring sustainability As discussed in chapter 1, sustainability reporting is becoming more and more important for businesses. 🞂

A sustainability report should cover the three ESG areas and include a range of ESG metrics (actual performance against targets and targets for the coming year).

🞂

A small selection of example performance indicators to include in a sustainability report are sown below:

ESG area

Examples of ESG factors

Examples of ESG metrics

Environment

🞂 🞂

Greenhouse gas emissions Waste generation

Absolute emissions (such as CO2g) Percentage of waste recycled

Social

🞂 🞂

Employment Health and safety

Staff satisfaction Number of notifiable accidents

Governance

🞂 🞂

Management diversity Ethical behaviour

Number of women in the management team Employee anti-corruption training

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7.2 World Economic Forum (WEF) Global Risks Report The WEF’s annual Global Risks Report explores some of the most severe risks the world may face over the next decade. It is underpinned by the annual Global Risks Perception Survey, bringing together leading insights from over 1,200 experts across the WEF’s diverse network. 🞂

These reports provide insight to organisations seeking to identify and evaluate their ESG impacts and dependencies for monitoring and reporting.

🞂

The WEF International Business Council (IBC) metrics provide a useful starting point when considering which ESG metrics may be relevant for an organisation.

🞂

These ESG metrics are categorised into four pillars: – – – –

Principles of governance Planet People Prosperity

7.3 Taskforce on Climate-related Financial Disclosures (TCFD) The TCFD began as a voluntary set of recommendations after growing demand by stakeholders for improved disclosure of climate-related risks and opportunities for decision-useful, climate-related financial information. 🞂

These recommendations (now mandatory in some jurisdictions) include the provision of climate-related metrics and information needed to undertake robust and consistent analysis of the potential financial impacts of climate change.

🞂

The TCFD focus their recommendations on forward-looking financial disclosure. They ask organisations to identify climate-related risks and opportunities, to consider the financial implications and to assess the resilience of the business strategy to future climate outcomes.

🞂

To achieve this, TCFD have provided guidance and recommendations of climate-related risk disclosure around four core elements:

Element

Description

Governance

Details of the organisation’s governance around climate-related risks and opportunities.

Strategy

The actual and potential impacts of climate-related risks and opportunities on an organisation’s business, strategy and financial planning.

Risk management

The processes used by an organisation to identify, assess, and manage climaterelated risks, which can be categorised into impacts and dependencies.

Metrics and targets

The metrics and targets used to assess and manage relevant climate related risks and opportunities.

Climate-related risks Climate-related risks can be divided into two major categories: transition risks and physical risks: Risk type

Description

Transition risks

The risks that relate to social and economic shifts to a lower-carbon economy such as changes to policy, regulation, technology and market.

Depending on the nature, speed, and focus of these changes, transition risks may pose varying levels of financial and reputational risk to organisations.

Management Infor mation

8: Perfo rmance manageme nt

Risk type

Description

Physical risks

The risks that arise from the physical effects of climate change such as storms, extreme temperatures, wildfires and flooding.

They can be event-driven (acute) or longer-term shifts (chronic) in climate patterns.

7.4 Difficulties measuring ESG performance A business may measure its performance using key performance indicators (KPIs). However, in practice, it can often be difficult or impossible to quantify ESG performance for the following reasons: 🞂

The choice of KPIs often involves a certain degree of subjectivity.

🞂

Qualitative effects can be difficult to measure (e.g. employee satisfaction).

🞂

KPIs that are not sufficiently specific may be hard to measure (eg reducing environmental damage).

🞂

It can be difficult to compare the ESG metrics of different businesses because different industries may lead to different impacts.

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Do you know Hopwood’s styles of evaluation?

Do you know the advantages and disadvantages of decentralisation?

Can you describe cloud accounting and its features?

Do you know the performance measures suitable for each type of responsibility centre?

Can you explain the balanced scorecard?

Do you know the difference between fixed and flexible budgets?

Do you know some examples of ESG metrics?

Yes/No

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113

9 Standard costing and variance analysis

Topic List 1

Standard costing and standard costs

2

Variances analysis

3

Sales variances

4

Materials variances

5

Labour variances

6

Overhead variances

7

Operating statements

8

Interpreting variances

Learning objectives 🞂

Calculate differences between actual performance and standards in terms of price and volume effects and identify possible reasons for those differences

🞂

Calculate and reconcile budgeted and actual profits using standard marginal costing

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1 Standard costing and standard costs 1.1 Standard costing Standard costing involves: 🞂

The establishment of predetermined estimates of the costs of products or services (‘standard costs’, to be recorded in a standard cost card).

🞂

The recording of actual costs and comparison of the actual costs with the predetermined estimates.

1.2 Standard costs A standard cost per unit is the expected, or normal, cost per unit, based on expectations for: 🞂

The usage of resources

🞂

The price per unit of resources

For example, the standard cost card for a BakeCo sponge cake would look like: Eggs Sugar Flour Butter Direct labour Variable overheads Variable production cost

Quantity 0.2 kg 0.225 kg 0.225 kg 0.225 kg 0.2 hours 0.2 hours

Price / Rate £3.00/kg £2.00/kg £1.20/kg £4.40/kg £10/hour £0.80/hour

Cost per unit £0.60 £0.45 £0.27 £0.99 £2.00 £0.16 £4.47

These standard costs can then be used to: 🞂

Produce budgets / forecasts (chapter 6)

🞂

Compare actual performance to budgeted performance (variance analysis – in this chapter)

1.3 Advantages and disadvantages of standard costing Advantages of standard costing

Disadvantages / difficulties of standard costing

It aids more accurate budgeting

It’s harder to apply to service industries which don’t have a typical product / cost unit (as each job is bespoke)

Provides a benchmark against which actual costs can be measured.

It is harder to standardise the service provided if the provision of services is mostly using staff (rather than machines)

They set efficiency targets for staff and engender a cost-conscious mindset Allows variance analysis to take place They can simplify bookkeeping and aid production scheduling They set targets which may motivate staff

Management Infor mation

9: Standar d costing and va riance a nalys is

2 Variance analysis The process by which the total difference between standard and actual results is analysed is known as variance analysis. 🞂

When actual results are better than expected results, we have a favourable variance (F).

🞂

When actual results are worse than expected results, we have an adverse variance (A).

As discussed in Chapter 8, in order to make meaningful comparisons between our original fixed budget (produced at the start of the period) and our actual results, the budget will need to be flexed to the actual activity level: 🞂

That is to say that a flexed budget will need to be calculated, which will show the original budget numbers scaled up / down for the actual number of units produced / sold.

🞂

Remember that fixed costs do not need to be flexed as they are unaffected by changes in volume.

WORKED EXAMPLE: BUDGET FLEXING AND BASIC VARIANCE ANALYSIS AceCo manufacture and sell tennis racquets. The standard cost of making a tennis racquet is shown below.

Standard cost for a tennis racquet Direct materials (0.3kg @ £30 per kg) Direct Labour (2hrs @ £12 per hr) Variable production overhead (2hrs @ £4 per hr) Variable (marginal) production cost Contribution per unit Selling price

£ 9.00 24.00 8.00 41.00 9.00 50.00

The following information relates to the production and sales for Month 2.

Budget Sales/production volume

15,000 racquets

Actual Sales/production volume Materials cost Labour cost Variable overhead Revenue

18,000 racquets £165,000 for 5,600 kg £405,000 for 33,000 hours £135,000 £885,000

Using the above information, we can calculate: 🞂

The original (‘fixed’) budget (based on the standard cost card information and 15,000 racquets produced / sold

🞂

The actual results (based on actual materials / labour / variable overhead costs and 18,000 racquets produced / sold

However, these are not directly comparable, as one is based on 15,000 racquets sold and the other is based on 18,000 racquets sold. 🞂

Hence, we also need to calculate the flexed budget, which uses the standard costs and the actual activity level of 18,000 racquets sold.

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Original

Flexed

Actual

Sales units

15,000 £

18,000 £

18,000 £

Revenue

750,000

900,000

Sales price variance £15,000 (A)

885,000

Less costs: Materials

135,000

162,000

165,000

Labour

360,000

432,000

Total material variance £3,000 (A) Total labour variance £27,000 (F)

Var O/H

120,000

144,000

Total overhead variance £9,000 (F)

135,000

Contribution

135,000

Sales volume variance £27,000 (F)

162,000

405,000

180,000

Now that we have calculated the flexed budget, we can perform detailed variance analysis to understand the reasons for any differences between the actual results and our expectations.

3 Sales variances The variance analysis we perform will ultimately explain the difference between AceCo’s original budgeted profit of £135,000 and the £180,000 actual profit they made.

The first step on this journey is to explain the profit difference between the original budget and the flexed budget – this is the Sales Volume Variance.

3.1 Sales volume variance 🞂

The sales volume variance is the difference between the actual units sold and the budgeted quantity, valued at the standard contribution per unit.

🞂

In other words, it measures the increase or decrease in contribution as a result of the sales volume being higher or lower than budgeted.

🞂

In the case of AceCo this is calculated as: Actual sales volume (units) Budgeted sales volume (units) Variance (units) Valued at standard contribution per unit Sales volume variance (favourable)

🞂

18,000 15,000 3,000 F £9 £27,000

I.e. AceCo expected to make an additional £27,000 in contribution due to selling 3,000 more racquets that expected.

3.2 Sales price variance 🞂

Having explained the difference between the original budgeted profit and the flexed profit, we now must focus on explaining the differences between the flexed budget and the actuals, starting with sales revenue.

🞂

Having already accounted for the impact of selling 3,000 extra racquets (the sales volume variance), the only remaining reason that can explain why our actual revenue was lower than our flexed budget revenue is the price we sold our racquets at → the sales price variance.

Management Infor mation

🞂

The sales price variance explains the difference between the actual revenue and the flexed budget revenue (actual units sold x budgeted price per unit) and is calculated as follows for AceCo: Actual sales revenue Expected sales revenue (18,000 × £50) Sales price variance (adverse)

🞂

9: Standar d costing and va riance a nalys is

£885,000 £900,000 (£15,000)

I.e. AceCo generated £15,000 less revenue than expected, due to selling racquets at a lower average price than the £50 per racquet expected.

3.3 Sales variances summary Variance

How to calculate it

What it tells us

Sales volume variance

(Actual units sold - Budgeted units sold) × Budgeted contribution per unit

Extra standard contribution earned from extra units sold vs. budget

Sales price variance

Actual units sold × (Actual sales price per unit – Budgeted sales price per unit)

Extra revenue earned from extra price per unit charged on actual units sold

INTERACTIVE QUESTION 1: SALES VARIANCES

[DIFFICULTY LEVEL: INTERMEDIATE]

A company budgets to sell 8,000 units of product J for £12 per unit. The standard variable cost per unit is £7. Actual sales were 7,700 units, at a price of £12.50 per unit.

Calculate the following variances. (a) (b)

The sales price variance The sales volume variance

SOLUTION

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4 Material variances 4.1 The total material variance All of our cost variances will be calculated based on the actual units produced (as they are explaining the difference between the actuals and the flexed budget, which are both based on the actual units). 🞂

The total material variance measures the difference between the standard material cost of the output produced and the actual material cost incurred – we can see this is an adverse total variance of £3,000 for AceCo, calculated as: Expected materials cost (18,000 units × £9/unit) Actual materials cost Total materials variance (adverse)

🞂

£162,000 £165,000 (£3,000)

However, this variance is driven by two separate factors: the quantity of materials used and the price we paid for those materials, hence we must split the variance into: –

The material usage variance (which focuses on the quantity of materials used).

–

The materials price variance (which focuses on the price paid for the materials).

4.2 The material usage variance 🞂

The materials usage variance measures the difference between the standard quantity of materials that should have been used for the number of units actually produced, and the actual quantity of materials used, valued at the standard price per unit of material.

🞂

In other words, it is the difference between how much material should have been used and how much material was used, valued at standard price.

🞂

In the case of AceCo this is calculated as: Expected materials used (18,000 × 0.3kg)

5,400kg

Actual materials used

5,600kg

Variance (kg)

(200) A

Valued at standard price per kg

£30

Materials usage variance (adverse)

🞂

(£6,000)

I.e. AceCo used more material per racquet than expected, leading to increased costs of £6,000.

4.3 The material price variance 🞂

This is the difference between the standard cost and the actual cost for the actual quantity of material used or purchased.

🞂

In other words, it is the difference between what the material did cost and what it should have cost.

🞂

In the case of AceCo this is calculated as: Expected cost of materials used (5,600kg × £30/kg) Actual cost of materials used Materials price variance (favourable)

£168,000 £165,000 £3,000

🞂

I.e. AceCo paid less per kg than expected for materials purchased, saving £3,000.

🞂

Note: the materials usage variance (£6,000 adverse) plus the materials price variance (£3,000 favourable) reconciles to the total materials cost variance (£3,000 adverse).

Management Infor mation

🞂

9: Standar d costing and va riance a nalys is

Note: whether the price variance is calculated on actual materials used or actual materials purchased depends on how closing inventory is valued: –

If closing inventories are valued at standard cost, the price variance should be calculated using actual materials purchased in the period.

–

If closing inventories are valued at actual cost, the price variance should be calculated using actual materials used in the period.

4.4 Materials variances summary Variance

How to calculate it

What it tells us

Total Material Variance

(Actual units produced × Budgeted materials cost per unit) – Actual total materials cost

Material Usage (Actual units produced × Budgeted materials cost Variance per unit) – (Actual total material quantity × Budgeted material price per kg)

Extra standard cost incurred from extra kgs/unit used in production vs. flexed budget

Material Price Variance

Extra price paid per kg for actual kgs purchased

(Actual total material quantity × Budgeted material cost per kg) – Actual total materials cost

INTERACTIVE QUESTION 2: MATERIALS VARIANCES

[DIFFICULTY LEVEL: INTERMEDIATE]

Product X has a standard material cost as follows.

10 kilograms of material Y at £10 per kilogram = £100 per unit of X. During period 4, 1,000 units of X were manufactured, using 11,700 kilograms of material Y which cost £98,631.

Requirement Calculate the following variances. (a)

The material total variance

(b)

The material price variance

(c)

The material usage variance

SOLUTION

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5 Labour variances 5.1 The total labour variance The calculation of labour variances is very similar to the calculation of material variances. 🞂

The total labour variance measures the difference between the standard labour cost of the output produced and the actual labour cost incurred – we can see this is a favourable total variance of £27,000 for AceCo, calculated as: Expected labour cost (18,000 units × £24/unit) Actual labour cost Total labour variance (favourable)

🞂

£432,000 £405,000 £27,000

However, this variance is driven by two separate factors: the hours of labour time worked and the rate we paid for those hours, hence we must split the variance into: –

The labour efficiency variance (which focuses on the number of hours worked).

–

The labour rate variance (which focuses on the rate paid per hour).

5.2 The labour efficiency variance 🞂

This is similar to the material usage variance. It is the difference between the hours that should have been worked for the number of units actually produced, and the actual number of hours worked, valued at the standard rate per hour.

🞂

In other words, it is the difference between how many hours should have been worked and how many hours were worked, valued at standard rate.

🞂

In the case of AceCo this is calculated as: Expected hours worked (18,000 × 2hrs) Actual hours worked Variance (hours) Valued at standard rate per hour Labour efficiency variance (favourable)

🞂

36,000 hrs 33,000 hrs 3,000 F £12 £36,000

I.e. AceCo staff worked fewer hours per racquet than expected, leading to a £36,000 cost saving.

5.3 The labour rate variance 🞂

This is similar to the material price variance. It is the difference between the standard cost and the actual cost for the actual number of hours paid for.

🞂

In other words, it is the difference between what the actual labour used did cost and what it should have cost.

🞂

In the case of AceCo this is calculated as: Expected cost of hours worked (33,000hrs × £12/hr) Actual cost of hours worked Labour rate variance (adverse)

£396,000 £405,000 (£9,000)

🞂

I.e. AceCo paid more per labour hour than expected for the hours worked, leading to a cost increase of £9,000.

🞂

Note: the labour efficiency variance (£36,000 favourable) plus the labour rate variance (£9,000 adverse) reconciles to the total labour cost variance (£27,000 favourable).

Management Infor mation

9: Standar d costing and va riance a nalys is

5.4 Labour variances summary Variance

How to calculate it

What it tells us

Total Labour Variance

(Actual units produced × Budgeted labour cost per unit) – Actual total labour cost

Labour Efficiency (Actual units produced × Budgeted labour cost Variance per unit) – (Actual total labour hours worked × Budgeted labour cost per hour) Labour Rate Variance

Extra standard cost incurred from extra hours worked in production vs. flexed budget

(Actual total labour hours for × Budgeted labour Extra cost per hour incurred on actual cost per hour) – Actual total labour cost hours paid for

INTERACTIVE QUESTION 3: LABOUR VARIANCES

[DIFFICULTY LEVEL: INTERMEDIATE]

The standard labour cost of product X is as follows.

2 hours of grade Z labour at £10 per hour = £20 per unit of product X. During period 4, 1,000 units of product X were made, and the labour cost of grade Z labour was £17,825 for 2,300 hours of work.

Requirement Calculate the following variances. (a) (b) (c)

The labour total variance The labour rate variance The labour efficiency variance

SOLUTION

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6 Overhead variances 6.1 Total variable overhead variance Variable overhead variances are very similar to labour variances (as they are both impacted by hours worked). 🞂

The variable production overhead total variance measures the difference between the variable production overhead that should be used for actual output and the variable production overhead actually used.

🞂

We can see this is a favourable total variance of £9,000 for AceCo, calculated as: Expected variable overhead cost (18,000 units × £8/unit) Actual variable overhead cost Total variable overhead variance (favourable)

🞂

£144,000 £135,000 £9,000

However, this variance is driven by two separate factors: the hours of labour time worked and the variable overhead cost charged for those hours, hence we must split the variance into: –

The variable overhead efficiency variance (which focuses on the number of hours worked).

–

The variable overhead expenditure variance (which focuses on the overhead cost charged paid per hour).

6.2 Variable overhead efficiency variance 🞂

This is similar to the labour efficiency variance. It is the difference between the hours that should have been worked for the number of units actually produced, and the actual number of hours worked, valued at the standard variable overhead charge per hour.

🞂

In other words, it is the difference between how many hours should have been worked and how many hours were worked, valued at standard cost per hour.

🞂

In the case of AceCo this is calculated as: Expected hours worked (18,000 × 2hrs) Actual hours worked Variance (hours) Valued at standard cost per hour Variable overhead efficiency variance (favourable)

🞂

36,000 hrs 33,000 hrs 3,000 F £4 £12,000

I.e. AceCo staff worked fewer hours per racquet than expected, leading to a £12,000 variable overhead cost saving.

6.3 Variable overhead expenditure variance 🞂

This is similar to the labour rate variance. It is the difference between the standard variable overhead cost and the actual cost for the actual number of hours worked.

🞂

In other words, it is the difference between what the hours worked cost (in variable overheads) and what they should have cost.

🞂

In the case of AceCo this is calculated as: Expected cost of hours worked (33,000hrs × £4/hr) Actual overhead cost of hours worked Variable overhead expenditure variance (adverse)

£132,000 £135,000 (£3,000)

Management Infor mation

9: Standar d costing and va riance a nalys is

🞂

I.e. AceCo were charged more variable overheads per hour than expected, leading to a cost increase of £3,000.

🞂

Note: the variable overhead efficiency variance (£12,000 favourable) plus the variable overhead expenditure variance (£3,000 adverse) reconciles to the total variable overhead cost variance (£9,000 favourable).

6.4 Variable overhead variances summary Variance

How to calculate it

What it tells us

Total Variable Overhead Variance

(Actual units produced × Budgeted variable overhead cost per unit) – Actual total variable overhead cost

Variable Overhead Efficiency Variance

(Actual units produced × Budgeted variable overhead cost per unit) – (Actual total labour hours worked × Budgeted variable overhead cost per hour)

Variable Overhead Expenditure Variance

(Actual total labour hours worked × Budgeted variable Extra cost per hour incurred overhead cost per hour) – Actual total variable on actual hours worked overhead cost

Extra standard cost incurred from extra hours worked in production vs. flexed budget

WORKED EXAMPLE: VARIABLE OVERHEAD VARIANCES Suppose that the standard variable overhead cost of product X is 2 hours at £1.50 = £3 per unit During the latest period, 400 units of product X were made. The labour force worked 760 hours. The variable overhead cost was £1,672.

Calculate the following variances. (a) (b) (c)

The variable overhead total variance The variable overhead expenditure variance The variable overhead efficiency variance

SOLUTION (a)

The variable overhead total variance This is similar to the labour total variance. It is the difference between the standard variable overhead cost of 400 units and the actual variable overhead cost incurred.

400 units of product X should cost (£3) Did cost Variable overhead total variance

(b)

£ 1,200 1,672 472 (A)

The variable overhead expenditure variance This is the difference between the amount of variable overhead that should have been incurred in the actual hours worked, and the actual amount of variable overhead incurred.

760 hours of variable overhead should cost (× £1.50) Did cost Variable overhead expenditure variance

£ 1,140 1,672 532 (A)

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The variable overhead efficiency variance 400 units of product X should take (× 2 hrs) Did take Variable overhead efficiency variance in hours Standard rate per hour Variable overhead efficiency variance in £

800 hrs 760 hrs 40 hrs (F) × £1.50 £60 (F)

If the variable overhead rate is stated in terms of a rate per labour hour, the variable overhead efficiency variance is exactly the same, in hours, as the labour efficiency variance, and occurs for the same reasons.

However, the variable overhead rate is sometimes stated in terms of a rate per machine hour, in which case the difference must be calculated between the actual machine hours and the standard machine hours for the output achieved.

The difference in hours, whether expressed in terms of labour hours or in terms of machine hours, is evaluated at the standard variable overhead rate per hour. (d)

Summary Variable overhead expenditure variance Variable overhead efficiency variance Variable overhead total variance

£ 532 (A) 60 (F) 472 (A)

6.5 Fixed overhead expenditure variance The fixed overhead expenditure variance is simply the difference between the budgeted and actual fixed overhead expenditure in the period.

By definition, fixed overheads should remain the same, regardless of the volume of production and sales → hence. any difference between budget and actual spending must be due to higher-thanexpected or lower-than-expected spending and can have nothing to do with differences in volume of activity. 🞂

The fixed overhead expenditure variance is: Budgeted fixed overhead cost – Actual fixed overhead cost

7 Operating statements If you encounter variance analysis in a long-form scenario question, you will likely be required to complete an operating statement. 🞂

This is simply a schedule that reconciles the actual profit to the original profit, with the differences explained using the variances we have just studied.

🞂

An operating statement for AceCo would look as follows:

Management Infor mation

9: Standar d costing and va riance a nalys is

WORKED EXAMPLE: OPERATING STATEMENT AceCo’s operating statement for Month 2 is as follows: Favourable £ Budgeted contribution Sales volume variance Sales price variance Materials usage variance Materials price variance Labour efficiency variance Labour rate variance Variable overhead efficiency variance Variable overhead expenditure variance Total variances Actual contribution

Adverse £

£ 135,000

27,000 15,000 6,000 3,000 36,000 9,000 12,000 78,000

3,000 33,000

45,000 180,000

8 Interpreting variances 8.1 Causes of variances Variance

Possible causes if favourable

Possible causes if adverse

Sales volume

🞂 🞂 🞂

🞂 🞂

🞂 Sales price

🞂 🞂 🞂

🞂

Supply shortages meant customers 🞂 prepared to pay higher prices Quantity discounts given to customers 🞂 were lower than expected Original standard selling price set too 🞂 low

Demotivated sales force Competitor increased advertising effort Original budgeted sales were too optimistic Supply surplus meant customers wished to pay lower price Quantity discounts given to customers were higher than expected Original standard selling price set too high

🞂 🞂

Material used of higher quality than standard More effective use made of material Errors in allocating material to jobs

🞂 🞂 🞂 🞂 🞂

Defective material Excessive waste Theft Stricter quality control Errors in allocating material to jobs

Materials price 🞂 🞂 🞂

Unforeseen discounts received More care taken in purchasing Material standard price set too high

🞂 🞂 🞂

Price increase in the market Careless purchasing Material standard price set too low

Materials usage

🞂

Efficient sales force Successful advertising campaign Potential market was larger than expected Original budgeted sales were very conservative

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126 9: Standa rd costing and varia nce analysis Variance

Possible causes if favourable

Labour efficiency

🞂

🞂

Management Infor mation

Possible causes if adverse

Output produced more quickly than 🞂 expected because of work motivation, better quality of equipment or 🞂 materials, or better methods 🞂 Errors in allocating time to jobs 🞂

Labour rate

🞂

Use of apprentices or other workers at 🞂 a rate of pay lower than standard 🞂

Variable overhead efficiency

As for labour efficiency (if based on labour hours)

Variable overhead expenditure

Change in types of overhead or their cost

Lost time in excess of standard allowed Output lower than standard set because of deliberate restriction, lack of training, or substandard material used Errors in allocating time to jobs Wage rate increase Use of higher-grade labour

Change in types of overhead or their cost

Fixed overhead Fixed overheads include a wide range of different items of expense. Any of these might expenditure be higher or lower than budgeted. For example, rent, rates or insurance for the period might be higher or lower than budgeted

8.2 Inter-relationships between variances Individual variances should not be looked at in isolation. One variance might be interrelated with another, and much of it might have occurred only because the other, inter related, variance occurred too.

Here are some examples of inter-related variances. (a)

(b)

(c)

Materials price and usage 🞂

It may be decided to purchase cheaper, lower quality materials for a job in order to obtain a favourable price variance, possibly with the consequence that materials wastage is higher and an adverse usage variance occurs.

🞂

If the cheaper materials are more difficult to handle, there might also be an adverse labour efficiency variance and an adverse variable overhead efficiency variance.

🞂

If a decision is made to purchase more expensive materials, which perhaps have a longer service life, the price variance will be adverse but the usage variance might be favourable.

Labour rate and efficiency 🞂

If employees are paid higher rates for experience and skill, using a highly skilled team o t do some work would incur an adverse rate variance, but should also obtain a favourable efficiency variance.

🞂

In contrast, a favourable rate variance might indicate a larger than expected proportion of inexperienced workers in the workforce, which could result in an adverse labour efficiency variance, and perhaps poor materials handling and high rates of wastage or product rejections (adverse material usage variance).

Sales price and sales volume 🞂

The inter-relationship between sales price and sales volume variances should (hopefully) be obvious to you. A reduction in the sales price might stimulate bigger sales demand, so that an adverse sales price variance might be offset by a favourable sales volume variance.

Management Infor mation

🞂 (d)

9: Standar d costing and va riance a nalys is

Similarly, a price rise would give a favourable price variance, but possibly at the cost of a fall in demand and an adverse sales volume variance.

Cost and sales variances (i)

If there are favourable cost variances (perhaps cheaper labour or material have been used, say, so that there are favourable labour rate or material price variances), the possible drop in quality of the product could lead to an adverse sales volume variance because customers don’t wish to buy the lower quality product.

(ii)

If product quality is improved this might result in an adverse cost variance. 🞂

If more expensive material is used (adverse material price variance)

🞂

If labour are more careful in production of the product and hence take longer than standard (adverse labour efficiency variance)

🞂

If more skilled labour is used (adverse labour rate variance)

But the change in quality might result in a favourable sales volume variance because customers want to buy more of the higher-quality product or a favourable sales price variance as a higher price could be charged for the better-quality product. (iii)

if costs have risen (resulting in adverse labour rate, material price and variable overhead expenditure variances), the sales price might have to be increased to cover the extra costs. This would result in a favourable sales price variance, but could lead to an adverse sales volume variance.

8.3 Deriving actual data from standard cost details and variances Variances can be manipulated to derive actual data from standard cost details.

INTERACTIVE QUESTION 4: DERIVING ACTUAL DATA

[DIFFICULTY LEVEL: HARD]

The standard marginal cost card for the TR, one of the products made by P Co, is as follows.

Material 16 kgs @ £6 per kg Labour 6 hours @ £12 per hour

£ 96 72 168

P Co reported the following variances in control period 13 in relation to the TR. Material price: £18,840 favourable Material usage: £480 adverse Labour rate: £10,598 adverse Labour efficiency: £8,478 favourable Actual wages cost £171,320. P Co paid £5.50 for each kg of material. There were no opening or closing inventories of the material.

Requirement Calculate the following. (a) (b) (c) (d)

Actual output Actual hours worked Average actual wage rate per hour Actual number of kilograms purchased and used

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Management Infor mation

SOLUTION

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Do you understand what a standard cost is?

Can you calculate all types of cost variance?

Can you calculate sales variances?

Do you know what an operating statement is?

Do you know the possible reasons for variances?

Do you understand how some variances can be interrelated?

Yes/No

129

10 Breakeven analysis and limiting factor analysis

Topic List 1

Breakeven analysis and contribution

2

Breakeven charts

3

Limiting factor analysis

Exam context 🞂

Calculate the breakeven point, contribution and margin of safety for a given product or service

🞂

Allocate scarce resources to those products and services with the highest contribution per unit of limiting factor

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1 Breakeven analysis and contribution As mentioned in chapter 5 when discussing transfer pricing, when making short-term decisions a company should focus on maximising contribution.

1.1 Contribution and breakeven As discussed in chapter 4 when looking at marginal costing: 🞂

Contribution per unit = sales price per unit less variable costs per unit

🞂

Total contribution is revenue less total variable costs

🞂

Total profit = total contribution less fixed costs

Breakeven analysis or cost-volume-profit (CVP) analysis is the study of the interrelationships between costs, volume and profit at various levels of activity. 🞂

Specifically, breakeven analysis looks to see how many units of a product we need to sell in order to make enough contribution to cover our fixed costs: Sales revenue Less: Variable costs Contribution Less: Fixed costs Profit (breakeven)

🞂

X (X) X (X) –

As we will see, this is useful information for the purposes of management decision-making when launching a new product.

1.2 Breakeven point From the above we can see that in order to break even (i.e. make zero profit): 🞂

Total contribution = Fixed costs

🞂

No of units sold × contribution per unit = Fixed costs

🞂

The number of sales units needed to break even is called the ‘breakeven point’

Breakeven point =

Fixed costs Contribution per unit

INTERACTIVE QUESTION 1: BREAKEVEN POINT

[DIFFICULTY LEVEL: EASY]

A company expects to sell 10,000 units of its product at £8 per unit in the next period. Variable costs are £5 per unit and fixed costs are £21,000.

Requirement Compute the breakeven point.

SOLUTION

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10 : Breakeve n ana lysi s and limiting factor analysis

1.3 Breakeven revenue As an alternative, the breakeven revenue can be calculated using the following formula: Breakeven point x sales price. It can also be calculated using the following shortcut: Breakeven revenue =

Fixed costs C/S ratio

🞂

Note: The contribution to sales ratio (c/s ratio) is contribution per unit divided by sales price per unit (also known as the profit/volume ratio).

🞂

The c/s ratio is a measure of how much contribution is earned from each £1 of sales revenue.

WORKED EXAMPLE: BREAKEVEN REVENUE Using the data in the last worked example the contribution ratio is £3/£8 = 37.5% Breakeven revenue therefore is £21,000/0.375 = £56,000. At a price of £8 per unit, this represents 7,000 units of sales, as calculated earlier.

INTERACTIVE QUESTION 2: BREAKEVEN

[DIFFICULTY LEVEL: EASY]

The contribution to sales ratio of product W is 20%. IB, the manufacturer of product W, wishes to make a contribution of £50,000 towards fixed costs.

If the selling price is £10 per unit, what is the number of units of W that must be sold?

SOLUTION

1.4 The margin of safety The margin of safety is a measure of how much sales would need to drop by before a loss is made and can be calculated either in units or as a %: Margin of safety (units) = Budgeted sales units – Breakeven sales units Margin of safety (%) = 🞂

Budgeted sales units – Breakeven sales units Budgeted sales units

The margin of safety can also be calculated in terms of revenue rather than units (Budgeted revenue less breakeven revenue).

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INTERACTIVE QUESTION 3: MARGIN OF SAFETY

[DIFFICULTY LEVEL: INTERMEDIATE]

Mal de Mer Co makes and sells a product which has a variable cost of £30 and which sells for £40.

Budgeted fixed costs are £70,000 and budgeted sales are 8,000 units.

Requirement Calculate the breakeven point and the margin of safety.

SOLUTION

1.5 Cost-volume-profit analysis and profit targets Once the selling price and cost structure have been established for a product or service, it is possible to manipulate the data to provide a variety of information for management decisions.

WORKED EXAMPLE: CVP ANALYSIS Butterfingers Company makes a product which has a variable cost of £7 per unit.

Requirement If fixed costs are £63,000 per annum, calculate the selling price per unit if the company wishes to break even with a sales volume of 12,000 units.

SOLUTION Contribution required to breakeven (= fixed costs) Volume of sales Required contribution per unit Variable cost per unit Required sales price per unit

= = =

= £63,000 = 12,000 units

£ 5.25 7.00 12.25

1.5.1 Target profit 🞂

The breakeven formulae can also be used to calculate the sales volume required in order to achieve a target profit: Units sold to achieve target profit =

Fixed costs + target profit Contribution per unit

Or Revenue required for target profit =

Fixed costs + target profit C/S ratio

Management Infor mation

10 : Breakeve n ana lysi s and limiting factor analysis

INTERACTIVE QUESTION 4: TARGET PROFITS

[DIFFICULTY LEVEL: INTERMEDIATE]

RB Co makes and sells a single product, for which variable costs are as follows.

Materials Labour Production overhead

£ per unit 10 8 6 24

The sales price is £30 per unit, and fixed costs per annum are £68,000. The company wishes to make a profit of £16,000 per annum.

Requirement Determine the sales required to achieve this profit.

SOLUTION

INTERACTIVE QUESTION 5: CHANGE IN PRODUCTION COSTS

[DIFFICULTY LEVEL: INTERMEDIATE]

Close Brickett Ltd makes a product which has a variable production cost of £8 and a variable selling cost of £2 per unit. Fixed costs are £40,000 per annum, the sales price per unit is £18, and the current volume of output and sales is 6,000 units.

The company is considering whether to hire an improved machine for production. Annual hire costs would be £10,000 and it is expected that the variable cost of production would fall to £6 per unit.

Requirements (a)

Determine the number of units that must be produced and sold to achieve the same profit as is currently earned, if the machine is hired.

(b)

Calculate the annual profit with the machine if output and sales remain at 6,000 units per annum.

SOLUTION

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Management Infor mation

2 Breakeven charts 2.1 Breakeven charts The breakeven point can be determined graphically using a breakeven chart. A breakeven chart is a chart that indicates the profit or loss at different levels of sales volume within a limited range.

Total Revenue (selling price x no of units sold)

£

Budgeted profit

BEP (revenue)

Total Cost (FC + VC)

Fixed costs Margin of safety

Output (units) BEP (units)

Management Infor mation

10 : Breakeve n ana lysi s and limiting factor analysis

2.2 Contribution breakeven charts The main problem with the traditional breakeven chart is that it is not possible to read contribution directly from the chart.

The contribution breakeven chart remedies this by drawing the variable cost line instead of the fixed cost line. This line will always run parallel to the total cost line.

Total Revenue (selling price x no of units sold)

£

Budgeted profit

BEP (revenue)

Total Cost (FC + VC)

Budgeted contribution

Variable Cost

Margin of safety

Output (units) BEP (units)

2.3 Limitations of breakeven or CVP analysis and breakeven charts CVP / breakeven analysis is a useful technique for managers. It can provide simple and quick estimates, and breakeven charts provide a graphical representation of breakeven arithmetic. It does, however, have a number of limitations: 🞂

It can only apply to a single product or a constant mix of a group of products.

🞂

It may be time-consuming to prepare.

🞂

It assumes that sales price per unit, variable cost per unit and total fixed costs are constant at all levels of output.

🞂

It assumes we produce the same number of units as we sell .

3 Limiting Factor Analysis 3.1 Limiting factors 🞂

When a business doesn’t have sufficient material or labour resource to produce enough units to satisfy sales demand, they must use limiting factor analysis to decide which product to prioritise in production.

🞂

It is critical to remember when dealing with optimum sales/production mix questions that fixed costs remain fixed and so will not be affected by the sales mix: –

Consequently, we will make our decision by calculating which products earn the most contribution per unit of limiting factor (e.g. contribution per kg of material).

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3.2 Steps to follow for limiting factor analysis Step 1: Identify the limiting factor. 🞂

Calculate the material and labour required to produce enough units of our products to meet the maximum sales demand.

🞂

Compare these figures to the maximum available material / labour hours to determine which is the limiting factor.

Step 2: Rank products according to contribution per unit of limiting factor.

Step 3: Work out optimum production plan. 🞂

Start by making enough units of the top-ranked product and see how much of the limited resource you have remaining afterwards.

🞂

Then move on and make as much of the 2nd ranked product as you can sell and keep going in descending ranking order until you run out of the limited resource.

WORKED EXAMPLE: OPTIMUM PRODUCTION PLAN WITH LIMITING FACTORS Short Co makes small and large hand-made special wooden fencing sections. Data for these two products are as follows: Wood per section Labour per section Maximum demand per week Contribution per section

Small 40kg 5 hours 26 sections £12

Large 80kg 7 hours 10 sections £21

Short Co can purchase 2,000kg of wood and has 140 hours of labour available each week.

Step 1: What is the limiting factor for Short Co? Based on the data above, our limiting factor could be wood, labour or sales demand. We check wood and labour first and if neither of them is limited, then we know it must be sales demand that is the limiting factor.

Material requirement Maximum wood requirement = (40kg × 26 sections) + (80kg × 10 sections) = 1,840 kg Maximum wood available = 2,000kg Therefore, wood is not a limiting factor.

Labour requirement Maximum labour requirement = (5 hours × 26 sections) + (7 hours × 10 sections) = 200 hours Maximum labour available = 140 hours Therefore, labour is a limiting factor.

Step 2: Rank products using contribution unit of limiting factor Contribution per section Labour hours required Contribution per labour hour Rank

Small £12 5 hours £2.40 2nd

Large £21 7 hours £3.00 1st

Thus, Large sections are the most profitable product for Short Co to produce first:

Management Infor mation

10 : Breakeve n ana lysi s and limiting factor analysis

Step 3: Identify optimum production plan Labour available Large sections use (7 hours × 10 sections) Labour available for Short sections

Hours 140 (70) 70

This will allow 70/5 = 14 Small sections to be made.

Thus, the optimal production plan is to produce 10 Large sections and 14 Small sections. This will generate a total contribution of (£21 × 10 sections) + (£12 × 14 sections) = £378 per week

INTERACTIVE QUESTION 6: LIMITING FACTOR

[DIFFICULTY LEVEL: INTERMEDIATE]

AB Ltd makes two products, the Ay and the Be. Unit variable costs are as follows.

Materials (£0.5 per kg) Labour (£9 per hour) Overhead

Ay £ 1 18 1 20

Be £ 3 9 1 13

The sales price per unit is £26 per Ay and £17 per Be. During July 20X2 the available labour is limited to 8,000 hours and the available material is limited to 38,000 kg.

Sales demand in July is expected to be 3,000 units for Ays and 5,000 units for Bes. Requirement Determine the profit-maximising production mix, assuming that monthly fixed costs are £20,000, and that no inventories are held.

SOLUTION

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3.3 Extra supply of a limiting factor It may later transpire that additional quantities of the limited resource become available and a business must decide how much it would be willing to pay to buy those extra units of resource. 🞂

The maximum premium a business would be willing to pay (in addition to the usual purchase price) to acquire extra units of a limited resource would be the additional contribution it could earn by using those additional units.

🞂

We can see this in operation by revisiting the previous worked example:

WORKED EXAMPLE: EXTRA SUPPLY OF A LIMITING FACTOR In the previous worked example we determined the following optimum production plan: Short Co can purchase 2,000kg of wood and has 140 hours of labour available each week. We determined that labour was a limiting factor.

Wood per section Labour per section Maximum demand per week Contribution per section Contribution per labour hour Optimum production plan

Small 40kg 5 hours 26 sections £12 £2.40 14 sections

Large 80kg 7 hours 10 sections £21 £3.00 10 sections

Requirement How much would Short Co be willing to pay for 10 more hours of labour time? The regular labour rate is £10 per hour.

SOLUTION As Short Co has already made enough Large panels to satisfy demand, it would make additional small panels if it had additional hours available: 🞂

With 10 additional hours it could make 10 hours / 5 hours = 2 small panels.

🞂

Making and selling 2 extra small panels would generate 2 × £12 = £24 of contribution.

🞂

Hence the maximum premium that Short Co would be willing to pay (in addition to the regular rate) for the extra 10 labour hours would be £24 (though if it paid this much there would be no benefit from making and selling the additional 2 small panels).

🞂

This would mean paying a total of 10 hours × £10 + £24 = £124 for the 10 extra hours.

3.4 Limiting factor analysis and restricted freedom of action In certain circumstances an organisation may also be restricted by a factor other than a scarce resource, for example: 🞂

A contract to supply a certain number of products to a customer which cannot be cancelled

🞂

Production/sales of a minimum quantity of one or more products to provide a complete product range and/or to maintain customer goodwill

🞂

Maintenance of a certain market share of one or more products

In each of these cases, the organisation might have to produce more of a particular product or products than the level established by ranking.

Management Infor mation

10 : Breakeve n ana lysi s and limiting factor analysis

🞂

In this instance, the products should be ranked in the normal way but the optimum production plan must first take into account the minimum production requirements.

🞂

The remaining resource must then be allocated according to the ranking.

WORKED EXAMPLE: RESTRICTED FREEDOM OF ACTION Harvey is currently preparing its budget for the year ending 30 September 20X2. The company manufactures and sells three products, Beta, Delta and Gamma.

The unit selling price and cost structure of each product is budgeted as follows.

Selling price Variable costs Labour Materials Overhead Total cost

Beta £ 100

Delta £ 124

Gamma £ 32

24 26 10 60

48 7 5 60

6 8 6 20

The labour rate is budgeted at £6 per hour, and fixed costs at £1,300,000 per annum. The company has a maximum production capacity of 228,000 labour hours.

A meeting of the board of directors has been convened to discuss the budget and to resolve the problem as to the quantity of each product which should be made and sold.

The sales director presented the results of a recent market survey which reveals that market demand for the company’s products will be as follows.

Product Beta Delta Gamma

Units 24,000 12,000 60,000

The production director proposes that since Gamma only contributes £12 per unit, the product should no longer be produced, and the surplus capacity transferred to produce additional quantities of Beta and Delta.

The sales director does not agree with the proposal. Gamma is considered necessary to complement the product range and to maintain customer goodwill. If Gamma is not offered, the sales director believes that sales of Beta and Delta will be seriously affected. After further discussion the board decided that a minimum of 10,000 units of each product should be produced.

Requirement Prepare a budget statement which clearly shows the maximum profit which could be achieved in the year ending 30 September 20X2.

SOLUTION

Step 1 Ascertain whether labour hours are a scarce resource Beta Delta Gamma

Units demanded 24,000 12,000 60,000

Labour hours are a limiting factor

Labour hours per unit 4 (£24/£6) 8 (£48/£6) 1 (£6/£6)

Total labour hours 96,000 96,000 60,000 252,000

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Management Infor mation

Step 2 Rank the products Since only 228,000 hours are available we need to establish which product earns the greatest contribution per labour hour.

Contribution per unit Labour hours Contribution per labour hour Ranking

Beta £40 4 £10 2nd

Delta £64 8 £8 3rd

Gamma £12 1 £12 1st

Step 3 Determine a production plan The optimum production plan must take into account the requirement that 10,000 units of each product are produced, and then allocate the remaining hours according to the above ranking.

Beta 10,000 units × 4 hours Delta 10,000 units × 8 hours Gamma 10,000 units × 1 hour

Gamma 50,000 units × 1 hour Beta 12,000 units × 4 hours (balance)

Hours 40,000 80,000 10,000 130,000 50,000 48,000 228,000

Step 4 Draw up a budget.

BUDGET STATEMENT £ Contribution Beta (22,000 units × £40) Delta (10,000 units × £64) Gamma (60,000 units × £12) Total contribution Fixed costs Profit

880,000 640,000 720,000 2,240,000 (1,300,000) 940,000

3.5 Make or buy decisions and scarce resources An organisation might want to do more things than it has the resources for, and so its alternatives would be as follows. (a)

Make the best use of the available resources and ignore the opportunities to buy help from outside

(b)

Combine internal resources with subcontracting externally so as to do more and increase profitability

If we take option (b), a further decision is then required on which parts of the work should be given to suppliers or subcontractors so as to maximise profitability.

In a situation where a company must subcontract work to make up a shortfall in its own in-house capabilities, its total costs will be minimised if those units bought have the lowest extra variable cost of buying per unit of scarce resource.

Management Infor mation

10 : Breakeve n ana lysi s and limiting factor analysis

Steps to follow for make-or-buy questions Step 1: Identify the extra cost of buying in (vs. making ourselves) for each product Step 2: Calculate the extra cost of buying in per unit of scarce resource saved for each product Step 3: Rank the products in ascending order of extra cost per unit of scarce resource saved (starting with the smallest).

Step 4: Buy in enough of the top-ranked products to enable us to make the lower-ranked products in-house.

INTERACTIVE QUESTION 7 MAKE OR BUY DECISIONS

[DIFFICULTY LEVEL: INTERMEDIATE]

MM manufactures three components, S, A and T using the same machines for each and assembles them into a single product. The budget for the next year calls for the production and assembly of 4,000 of each component. The variable production cost per unit of the final product is as follows.

Machine hours 1 unit of S 1 unit of A 1 unit of T Assembly

3 2 4

Variable cost £ 20 36 24 100

Only 24,000 hours of machine time will be available during the year, and a subcontractor has quoted the following unit prices for supplying components: S £29; A £40; T £34.

Requirement Advise MM on its most profitable plan.

SOLUTION

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INTERACTIVE QUESTION 8: MAKE OR BUY

Management Infor mation

[DIFFICULTY LEVEL: INTERMEDIATE]

HOME STUDY

TW manufactures two products, the D and the E, using the same material for each. Annual demand for the D is 9,000 units, while demand for the E is 12,000 units. The variable production cost per unit of the D is £10, and that of the E £15. The D requires 3.5 kgs of raw material per unit, the E requires 8 kgs of raw material per unit. Supply of raw material will be limited to 87,500 kgs during the year.

A sub-contractor has quoted prices of £17 per unit for the D and £25 per unit for the E to supply the product. How many of each product should TW manufacture in order to maximise profits?

Requirement Fill in the spaces in the sentences below: TW should manufacture TW should manufacture

units of D units of E to maximise profits.

WORKING

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Do you know the formulae for the breakeven point, contribution ratio and margin of safety?

Do you know how to incorporate a target profit into the breakeven formula?

Can you identify the total costs line, sales line, fixed cost line and breakeven point on a breakeven chart?

Do you know how to rank products in a limiting factor situation?

Yes/No

143

11 Investment appraisal techniques

Topic List 1

Making investment appraisal decisions

2

The payback period

3

The Accounting Rate of Return (ARR)

4

Net Present Value (NPV)

5

The Internal Rate of Return (IRR)

6

Environmental costs

Learning objectives 🞂

Calculate the net present value, internal rate of return, payback period or accounting rate of return for a given project

🞂

Identify and comment upon the advantages and disadvantages of the investment appraisal techniques specified above

🞂

Identify and classify environmental costs

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1 Making investment appraisal decisions 1.1 Investment appraisal techniques Businesses will regularly need to evaluate potential investments. These could include investing in new machinery, launching new products, or opening new factories or shops.

Investment appraisal techniques help us to evaluate whether to proceed with these investments.

In management information we will meet 4 different investment appraisal techniques: (1)

The payback period

(2)

The Accounting Rate of Return (ARR)

(3)

Net Present Value (NPV)

(4)

The Internal Rate of Return (IRR)

1.2 The investment decision-making process The usual process for appraising potential investments involves: 🞂

Origination of proposals: managers / staff are invited to propose investment ideas (e.g. expansion of production facilities, R&D on new product lines).

🞂

Project screening: initial screening (perhaps using payback period or ARR) are used to filter out some of the investment proposals.

🞂

Analysis and acceptance: the remaining proposals are subject to more detailed scrutiny (perhaps involving NPV / IRR calculations), with a final decision made on which project to proceed with.

🞂

Monitoring and review: post-commencement of the project, monitoring and review is performed to e.g. check spend vs. targets and to confirm that the anticipated project benefits are realised.

2 The payback period 2.1 Calculating the payback period Often used as an initial screening tool, the payback period is the time it takes for a project to repay its initial investment: 🞂

This is suited to appraising projects with initial cash outflows (e.g. to buy machinery / land) and subsequent cash inflows (e.g. contribution from selling a product).

🞂

The payback period calculation uses cashflows, not accounting profits. Hence, you may need to make adjustments if you are given profit figures (e.g. add-back non-cash expenditure such as depreciation).

🞂

The payback period assumes that all project cashflows (other than the initial investment and any proceeds from disposals of assets) are generated evenly throughout the year.

Management Infor mation

11 : Investm ent a pp raisa l techni qu es

INTERACTIVE QUESTION 1: PAYBACK PERIOD

[DIFFICULTY LEVEL: INTERMEDIATE]

An asset costing £120,000 is to be depreciated over ten years to a nil residual value. Profits after depreciation for the first five years are as follows: Year 1 2 3 4 5

£ 12,000 17,000 28,000 37,000 8,000

Requirement Calculate the payback period to the nearest month.

SOLUTION

2.2 Advantages and disadvantages of the payback period Advantages

Disadvantages

It is useful for initial screening of projects

It ignores the timing of cash flows within the payback period

It focuses on liquidity

It ignores cash flows after the end of the payback period

Choosing projects with shorter payback periods should help reduce risk

It ignores the time value of money

Shorter-term forecasts are likely to be more reliable

It cannot distinguish between projects with the same payback period

The calculation is quick and simple

It may lead to excessive investment in short-term projects

Payback is an easily understood concept

Ignores potential variability of cash flows

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3 The Accounting Rate of Return (ARR) 3.1 Calculating the accounting rate of return The accounting rate of return (ARR) method is similar to the return on investment method we met in chapter 8 and involves estimating the accounting rate of return that a project should yield. 🞂

This should align with how users of our accounts will view the project.

🞂

If the project exceeds a set target rate of return, then the project is acceptable.

🞂

There are two different ways of calculating the ARR: ARR =

Average annual accounting profit

× 100

Initial investment ARR =

Average annual accounting profit

× 100

Average investment – 🞂

The average investment is calculated as ½ × (initial investment + final or scrap value).

Note: this is the only appraisal method that we will be studying that uses accounting profits instead of cash flow.

INTERACTIVE QUESTION 2: THE ACCOUNTING RATE OF RETURN

[DIFFICULTY LEVEL: INTERMEDIATE]

A project involves the immediate purchase of plant at a cost of £110,000. It would generate annual profits before depreciation of £24,000 for five years. Scrap value will be £10,000 at the end of the fifth year.

Requirement Calculate the ARR using the initial and average investment.

SOLUTION

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11 : Investm ent a pp raisa l techni qu es

3.2 Advantages and disadvantages of Accounting Rate of Return Advantages

Disadvantages

it is quick and simple to calculate

it does not take account of the timing of the profits from a project

it involves a familiar concept of a percentage return (may be more easily understood)

it is based on accounting profits rather than cash flows

Accounting profits can be easily calculated from financial statements

it is a relative measure rather than an absolute measure and hence takes no account of the size of the investment

it looks at the entire project life

it takes no account of the length of the project

it allows more than one project to be compared

it ignores the time value of money

4 Net Present Value (NPV) 4.1 Timings of flows Before understanding the net present value method, we need to discuss: 🞂

Conventions for timings of cash flows

🞂

The concept of compound interest.

Cash flow timings We will use the following notation to show the timings of cashflows in MI:

T0

T1

T2

Today

In one year’s time

In two years’ time

4.2 Compounding If you deposit money in an interest-bearing bank account today, you will earn a rate of interest and the interest you earn will be added to the balance on your deposit account. 🞂

In MI we will assume that interest compounds annually – that is to say that it is calculated and credited to our deposit account at the end of each year. Crucially, the interest credited to our account will itself go on to earn interest in future periods.

🞂

Say we deposit £100 today into a deposit account paying 10% interest (annually compounding) –

In one year’s time we will be paid interest of £100 × 10% = £10. This will be credited to our account, increasing the balance to £110.

–

In year 2 we will now earn interest on the revised balance of £110 → £110 × 10% = £11.

This is credited to our account, so we now have a balance of £121

–

Per the below, at the end of the 5th year we will have a balance of £161.05 (we can refer to this as the future value at T5

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🞂

You can see that we are multiplying by 1.10 → i.e. (1+ the interest rate) each year in order to calculate the new year-end balance on the account.

🞂

Hence, to calculate the balance at the end of year 5, we have multiplied by 1.10 five times – this can be expressed as £100 × 1.105.

🞂

This leads to the general result that the future value of the money on our deposit account n years into the future will be £100 × 1.10n –

🞂

Hence, if we deposit £X at T0, the future value at Tn is X × (1 + 𝑟)𝑛

Hence, if we deposited £10,000 today into a bank account paying 5% annually compounding interest, in 8 years’ time the balance on the account would be £10,000 × 1.058 = £14,775

4.3 Discounting Discounting is the opposite of compounding – we start with the future value (a sum of money receivable or payable at a future date), and convert the future value to a present value, which is the cash equivalent now of the future value. 🞂

I.e. the present value X represents the amount we would need to place on deposit today at the annual-compounding interest rate r to reach a set future value S at time n and can be calculated 1 using the general formula X = 𝑆 × or X = 𝑆 × (1 + 𝑟)−𝑛 (1+𝑟)𝑛

🞂

For example, the present value of receiving £161.05 in 5 year’s time (if we have access to a 1 deposit account paying 10% annual compounding interest is £161.05 × = £100 1.15

🞂

This means that we would be indifferent to either receiving £100 today (which we could deposit at an annually compounding interest rate of 10%) or receiving £161.05 in 5 years’ time.

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11 : Investm ent a pp raisa l techni qu es

The interest rate (r) used when calculating the present value is the relevant interest rate (or cost of capital) to the entity in question → i.e the interest rate that represents the company’s cost of financing. In the exam this will always be made clear.

4.3.1 Discount tables for the PV 🞂

We refer to the

1 (1+𝑟)𝑛

in the present value formula as the ‘discount factor’ or ‘present value

factor’. 🞂

Instead of having to calculate the discount factor, we can use pre-calculated figures which can be found in tables in the Appendix at the back of the study manual in the first column of results in the ‘discount tables’ (and will be available in the exam software in the MI exam).

🞂

For example, the present value factor for 5 years and 10% is 0.621 → hence to find the present value of £161.05 received in 5 years’ time, if we have a cost of capital of 10% can be calculated as:

🞂

1

–

£161.05 × 1.15 = £100, or

–

£161.05 × 0.621 = £100

Note: there may be slight rounding differences between the two approaches, but this will never lead you to get the incorrect answer in the exam.

INTERACTIVE QUESTION 3: PRESENT VALUE CALCULATION

[DIFFICULTY LEVEL: INTERMEDIATE]

Spender expects the cash inflow from an investment to be £40,000 after two years and another £30,000 after three years. Its target rate of return is 12%.

Use the table below to calculate the present value of these future returns.

Year

Cash Flow

Discount Factor

Present Value

2 3 Total Present Value

4.4 Net present value (NPV) A typical project involves initial cash outflows, followed by subsequent cash inflows – e.g.

Timing Cash flow

T0 (100,000)

T1 20,000

T2 30,000

T3 40,000

T4 40,000

🞂

We can’t directly compare these values, as they are happening at different points – e.g. we know that the £40,000 at the end of year 3 is worth more to us than the £40,000 at the end of year 4 (as we get it earlier!).

🞂

Hence, to consider whether the project is worthwhile we need to get the cashflows on an equal footing → by finding their present values and adding them together (the Net Present Value).

🞂

We present valuing using the ‘cost of capital’ of the business – usually a combination of their cost of borrowing and the return their shareholders require.

🞂

In this case, if we were told the cost of capital was 5%, the NPV would be calculated as either: –100,000 +

20,000 30,000 40,000 40,000 + + + = 1𝟏𝟏, 𝟕𝟕𝟕𝟕𝟕𝟕 OR 1.05 1.052 1.053 1.054

–100,000 + 20,000 × 0.952 + 30,000 × 0.907 + 40,000 × 0.864 + 40,000 × 0.823 = 13,730

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🞂

In other words, if you borrowed £100,000 at 5%, invested it in this project, used any cash inflows to pay back the debt and deposited any surplus cash to earn 5%, you would end up with surplus cash with a present value of £13,720.

🞂

Note that the £10 difference in the result is due to the discount factors in the formula sheet being rounded to three decimal places.

🞂

Hence, the NPV represents the present value of the surplus cash you will be left with at the end of the project (after paying back any financing).

🞂

If the NPV is positive, it means the rate of return on the project is higher than your financing cost (the cost of capital) → This measures the change in shareholder wealth as a result of accepting a project.

Decisions made from the NPV 🞂

If the NPV is positive, it means that the cash inflows from a project will yield a return in excess of the cost of capital (required return), and so the project should be undertaken.

🞂

If the NPV is negative, it means that the cash inflows from a project will yield a return below the cost of capital, and so the project should not be undertaken.

🞂

If the NPV is exactly zero, the cash inflows from a project will yield a return which is exactly the same as the cost of capital.

INTERACTIVE QUESTION 4: NPV

[DIFFICULTY LEVEL: INTERMEDIATE]

Slogger has a cost of capital of 15% and is considering a capital investment project, where the estimated cash flows are as follows.

Year 0 (ie now) 1 2 3 4

Cash flow £ (100,000) 60,000 80,000 40,000 30,000

Requirement Calculate the NPV of the project and assess whether it should be undertaken.

SOLUTION

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4.5 Timing of cash flows: conventions used in DCF It is very easy to mis-interpret the wording in a NPV question in a MI exam – below is a guide to the language that might be used to describe cashflow timing: 🞂

A cash outlay to be incurred at the beginning of an investment project (‘now’) occurs in time 0

🞂

A cash flow which occurs during the course of a time period is assumed to occur all at once at the end of the time period (at the end of the year). Receipts of £10,000 during time period 1 are therefore taken to occur at the end of time period 1.

🞂

A cash flow which occurs at the beginning of a time period is taken to occur at the end of the previous time period. Therefore, a cash outlay of £5,000 at the beginning of time period 2 is taken to occur at the end of time period 1.

🞂

It is important to remember that DCF techniques are based on the cash flows of a project, not the accounting profits.

4.6 Annuities An annuity is a constant annual cashflow (with the cashflow at the end of each year and the first cashflow in one year’s time). 🞂

For example a 4 year £100 annuity would be: T0 –

🞂

T1 100

T2 100

T3 100

T4 100

To find the present value of an annuity, we could simply present value each cashflow – hence if the cost of capital was 5%, the present value of the annuity would be: 100 100 100 100 + + + = 𝟏𝟏𝟑𝟑𝟑𝟑 1.05 1.052 1.053 1.054

🞂

However we can also use a formula shortcut (given in the formula sheet) 1

1

𝑟

(1+𝑟)𝑛

The present value = 100 × (1 − 🞂

) = 100 ×

1

(1 −

0.05

1 1.054

:

) = 𝟏𝟏𝟑𝟑𝟑𝟑

You could also use the annuity factor from the 2nd column of results in the ‘discount factor’ table in the formula sheet provided → PV = 100 × 3.546 = 355

WORKED EXAMPLE: CALCULATING THE PRESENT VALUE OF AN ANNUITY Taking an annuity receivable at the end of years 1, 2 and 3, the present value assuming a 20% cost of capital, could be calculated as follows.

Year £ 1 2 3

Cash flow 30,000 30,000 30,000

Present value factor 20% 0.833 0.694 0.579

Present value of cash values £ 24,990 20,820 17,370

2.106

63,180

This calculation could, instead, be performed in one step using annuity factors (also given in the appendix to the study manual): £30,000 × 2.106 = £63,180 (NB The annuity factor is effectively the sum of the discount factors related to when the cash flows occur – i.e. a 3 year annuity factor is the sum of individual discount factors for periods 1,2 and 3).

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Other aspects of discounting using Annuities In order to use annuities tables the first annuity flow needs to arise at t1. 🞂

Hence, if the first cashflow is later than T1, we need to adapt our approach.

🞂

Take the example where our 4 year £100 annuity starts at T3: T0 –

T1 –

T2 –

T3 100

T4 100

T5 100

T6 100

🞂

Multiplying the annual cashflow by the annuity factor for 5% and 4 years gives the value of the annuity as at 1 year before the first cashflow.

🞂

Hence 100 × 3.546 = 355 is the equivalent single cash flow value of annuity as at T2

🞂

So, to find the present value, we need to discount the £355 back from T2 to T0 by multiplying by a 2-year 5% discount factor: £355 × 0.907 = £322 (the present value).

🞂

Alternatively, we could find the value of a 6-year £100 annuity and deduct the value of a 2-year £100 annuity: 100 × 5.076 – 100 × 1.859 = £322

🞂

This leads to the general result that the present value of an £A annuity starting at time y, ending at time n with a cost of capital of r% is either: –

PV = A × Annuity factor (n-y+1 years, r%) × Discount factor (y-1 years, r%) OR

–

PV = A × Annuity factor (n years, r%) – A × Annuity factor (y-1 years, r%)

INTERACTIVE QUESTION 5: ANNUITY TIMINGS

[DIFFICULTY LEVEL: HARD]

What is the present value of £1,000 received annually for five years if the first receipt is: (a) (b) (c)

In one year’s time?

Now? In three years’ time?

Use a discount rate of 15%.

SOLUTION

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4.7 Annual cash flows in perpetuity A perpetuity is a never-ending constant annual cashflow (with the cashflow at the end of each year and the first cashflow in one year’s time) 🞂

For example, a £100 perpetuity would be: T0 –

T1 100

T2 100

T3 100

T4 100

… … 𝐴

🞂

The present value of a perpetuity of £A p.a. can be found using the formula 𝑃𝑉 = where r is 𝑟 the relevant cost of capital.

🞂

We can use the same method as seen for annuities to present value delayed-start perpetuities.

WORKED EXAMPLE: PERPETUITIES (a)

What is the present value of £3,000 received in one year's time and forever if the annual interest rate is 10%?

(b)

What would be the present value if the first receipt is in four years' time?

SOLUTION

(a)

Present value = £3,000/0.10 = £30,000

(b) Method 1 Pretend the perpetuity starting at year 1

= £3,000/0.10

= £30,000 Then remove the annuity of 3 years you do not have: £3,000 × Annuity Factor 3 years 2.487 = £7,461 Thus answer is £30,000 – £7,461= £22,539 Method 2 – alternative method Present value one year before the first cash flow

= at end of year 3 = £3,000/0.10 = £30,000

Present value at year 0

= £3,000 × year 3 10% discount factor = £30,000 × 0.751 = £22,530

4.8 Net terminal value Net terminal value (NTV) is the cash surplus remaining at the end of a project after taking account of interest and capital repayments.

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The NTV discounted at the cost of capital will give the NPV of the project, so: 𝑵𝑵𝑃𝑉 = 𝑵𝑵𝑇𝑉 ×

1 (1+𝑟)𝑛

and 𝑵𝑵𝑇𝑉 = 𝑵𝑵𝑃𝑉 × (1 + 𝑟)𝑛

WORKED EXAMPLE: THE NET TERMINAL VALUE A project has the following cash flows.

Year 0 1 2 3

£ (5,000) 3,000 2,600 6,200

The project has an NPV of £4,531 at the company’s cost of capital of 10% (workings not shown).

Requirement Calculate the net terminal value of the project.

SOLUTION Assume that the £5,000 for the project is borrowed at an annual interest rate of 10% and that cash flows from the project are used to repay the loan. Two methods to understand this: T0

T1

T2

T3

(5,000) £3,000 £2,600 £6,200 T0: (£5,000) × 1.13 T1: £3,000 × 1.12 T2: £2,600 × 1.11 T3: £6,200 × 1

= (£6,655) = £3,360 = £2,860 = £6,200 £6,035

Assume that the £5,000 for the project is borrowed at an annual interest rate of 10% and that cash flows from the project are used to repay the loan.

Loan balance outstanding at beginning of project Interest in year 1 at 10% Repaid at end of year 1 Balance outstanding at end of year 1 Interest year 2 Repaid year 2 Balance outstanding year 2 Interest year 3 Repaid year 3 Cash surplus at end of project

The net terminal value is £6,035.

£ 5,000 500 (3,000) 2,500 250 (2,600) 150 15 (6,200) 6,035

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4.9 The time value of money NPV is a project appraisal technique that is based on the concept of the time value of money, that £1 earned or spent sooner is worth more than £1 earned or spent later. Various reasons could be suggested as to why a present £1 is worth more than a future £1. 🞂

Uncertainty

🞂

Inflation

🞂

Time preference

🞂

Opportunity cost of capital (£1 received today could be deposited in order to earn interest)

4.10 Advantages and disadvantages of NPV Advantages

Disadvantages

It is consistent with aim of maximising shareholder wealth

It assumes all cashflows happen at annual intervals

It considers the time value of money

You must estimate an appropriate cost of capital for all years of the project

It considers all relevant cash flows

As it deals with absolutes and gives a binary answer, it ignores capital rationing and risk preferences of clients

Risk can be incorporated into decision making by adjusting the cost of capital It provides clear, unambiguous decisions

4.11 Changing discount rates If the discount rate changes over time the net present value is calculated as shown below:

WORKED EXAMPLE: CHANGING DISCOUNT RATES A project’s estimated cash flows are as follows.

Cash flow

Year 0 £m (10)

Year 1 £m 6

Year 2 £m 8

Calculate the NPV if the cost of capital is 10% for the first year and 20% for the second year.

SOLUTION NPV = −£10𝑀 + £6𝑀(1.10)−1 + £8𝑀(1.10)−1 × (1.20)−1 Which is the same as NPV = −£10𝑀 + £6𝑀(1.10)−1 + £8𝑀 (1.10 × 1.20)−1 = £1.52m

4.12 Discounted payback The payback method can be combined with DCF to calculate a discounted payback period. 🞂

The discounted payback period (DPP) is identical to traditional payback except we calculate when the cumulative present value will reach zero to determine when the project will pay back.

WORKED EXAMPLE: DISCOUNTED PAYBACK PERIOD

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An asset costing £120,000 is to be purchased immediately. The cashflows for the first five years of the project are as follows: Year 1 2 3 4 5

£ 24,000 29,000 40,000 49,000 20,000

Requirement Calculate the discounted payback period if the cost of capital is 5%.

SOLUTION Timing 0 1 2 3 4 5

Cashflow (120,000) 24,000 29,000 40,000 49,000 20,000

Discount factor 1 0.952 0.907 0.864 0.823 0.784

Present value (120,000) 22,848 26,303 34,560 40,327 15,680

Cumulative PV (120,000) (97,152) (70,849) (36,289) 4,038 19,718

Hence, as we assume (for present valuing purposes) that all cash flows happen at the end of each year, the discounted payback period is 4 years (as we assume that we receive all of the £49,000 in year 4 on the last day of year 4).

5 The internal rate of return (IRR) 5.1 The internal rate of return (IRR) The IRR represents the actual annual % return on the project (based on discounted future cashflows). 🞂

If the IRR exceeds the business’ cost of capital, the project would be worth undertaking.

5.2 Finding the IRR using the interpolation method 🞂

As the NPV represents the value of the excess return over and above the cost of capital, if we can find a cost of capital that gives a zero NPV on the project then this cost of capital must equal the % return on the project (the IRR).

🞂

To find an approximate value for the IRR, we first find two different costs of capital, one (L%) which gives a positive NPV (NPVL) and another (H%) which gives a negative NPV (NPVH).

🞂

We then interpolate between the two to find an approximate IRR: NPVL IRR=L+ ×(H-L) (NPVL-NPVH)

🞂

Note that if we are appraising a ‘typical’ capital project with a negative cash flow at the start of the project and positive net cash flows afterwards up to the end of the project, we could draw a graph of the project’s NPV at different costs of capital which would resemble the below:

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INTERACTIVE QUESTION 6: THE IRR METHOD AND INTERPOLATION [DIFFICULTY LEVEL: INTERMEDIATE] A company is trying to decide whether to buy a machine for £80,000 which will save costs of £20,000 per annum for five years and which will have a resale value of £10,000 at the end of year 5.

Requirement If it is the company’s policy to undertake projects only if they are expected to yield a DCF return of 10% or more, ascertain using the IRR method whether this project should be undertaken.

SOLUTION

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5.3 NPV and IRR compared 5.3.1 Advantages and disadvantages of IRR The IRR method has a number of advantages and disadvantages when compared with the NPV method: Advantages of IRR (compared to NPV) method

Disadvantages of IRR (compared to NPV) method

The information it provides is more easily understood (as it’s a percentage measure)

If managers were given information about both ARR and IRR, it might be easy to get their relative meaning and significance mixed up.

A cost of capital does not have to be specified before the IRR can be calculated

It is inflexible (it is hard to appraise a project using the IRR if the cost of capital is expected to vary over the life of the project).

It ignores the relative size of investments.

It cannot be used when there are non-standard cashflows or to choose between mutually-exclusive projects.

5.3.2 Mutually exclusive projects 🞂

Due to the differences in the size of projects, it is possible to have conflicting rankings between NPV and IRR.

🞂

The NPV method is the superior technique and selecting projects on this basis will always ensure shareholder wealth maximisation is achieved when choosing between mutually exclusive projects.

5.3.3 Reinvestment assumption 🞂

An assumption underlying the NPV method is that any net cash inflows generated during the life of the project will be reinvested elsewhere at the cost of capital.

🞂

The IRR method, on the other hand, assumes these cash flows can be reinvested elsewhere to earn a return equal to the IRR of the original project (which may not be achievable and hence likely over-estimates the real return of the project).

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5.3.4 Non-conventional cash flows The projects we have considered so far have had conventional or normal cash flows (an initial cash outflow followed by a series of inflows) and in such circumstances the NPV and IRR methods give the same accept or reject decision. 🞂

When flows vary from this, they are termed non-conventional. Different patterns of cashflows will give rise to different NPV graphs and potentially multiple IRRs.

🞂

The rule is that maximum number of IRRs for a series of cashflows is equal to the number of sign-changes of its cash flows.

🞂

Below we will see projects with 1, 2 and 3 cash flow sign changes: 250,000

Graph 1: Initial outflow, then inflows

200,000 150,000 100,000

NPV

50,000 0 -50,000

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

16%

18%

20%

-100,000 -150,000 -200,000 -250,000 -300,000 t0 (800,000)

t1 100,000

300,000 250,000

t2 150,000

t3 200,000

t4 250,000

t5 300,000

Graph 2: Initial inflow, then outflows

200,000 150,000

NPV

100,000 50,000 0 -50,000 0%

2%

4%

6%

8%

10%

12%

-100,000 -150,000 -200,000 -250,000 t0 800,000

t1 (100,000)

t2 (150,000)

t3 (200,000)

t4 (250,000)

t5 (300,000)

14%

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100,000

Graph 3: 2 sign changes

50,000

NPV

0 0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

-50,000

-100,000

-150,000 t0 (500,000)

t1 –

t2 1,400,000

150,000

t3 –

t4 –

t5 (1,000,000)

Graph 4: 3 sign changes

NPV

100,000

50,000

0 0%

10%

20%

30%

40%

t3 –

t5 (1,300,000)

50%

60%

70%

80%

-50,000 t0 (600,000)

t1 1,200,000

t2 –

t4 –

T6 –

T7 –

T8 –

T9 –

T10 800,000

5.4 Drawing NPV graphs and decision-making using NPV graphs Drawing an NPV graph In the previous section we saw the following cashflows under graph 3: t0 (500,000)

🞂

🞂

t1 –

t2 1,400,000

t3 –

t4 –

t5 (1,000,000)

We could have sketched the graph for these cashflows if we were given the following information: –

The cashflows

–

The IRR(s)

If the cost of capital were zero, the NPV of the project would be equal to the sum of the cashflows (as all of the discount factors would be 1).

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–

The sum of these cashflows is -500,000 + 1,400,000 – 1,000,000 = -100,000

–

Hence, we know that when the cost of capital is zero, the NPV is -100,000 (i.e. the graph intersects the vertical axis at an NPV of -100,000).

If we are told the IRR(s) of the cashflows, we know when the NPV will be zero.

🞂

–

In this case, we would be told that the IRRs were roughly 6.11% & 47.55%

–

Hence, we know that the graph intersects the horizontal axis at 6.11% and 47.55%

By drawing a line through each of these points would result in the following graph: 100,000

50,000

Region in which the project is acceptable 0

NPV

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

-50,000

IRRs -100,000

Sum of the cashflows = -100,000 -150,000

Decision-making using NPV graphs A project will be acceptable as long as the NPV is positive (i.e. the line is above the horizontal axis). 🞂

Hence, in the above example the project is acceptable as long as the cost of capital is between 6.11% & 47.55%

6 Environmental costs Environmental costs should be integrated into the investment appraisal process alongside other operating cashflow. This fits into the ESG analysis we have already considered in chapters 1 and 8.

6.1 Benefits from environmental costing Organisations with good ESG practice seen as lower risk Poor environmental behaviour can lead to fines by banks and investors Financing decisions may be taken based on an organisation’s ESG performance

Recording environmental costs may be necessary for regulatory compliance

Identifying environmental costs can enable more appropriate pricing of goods/services

Cost savings can be identified (e.g. from reducing energy bills)

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6.2 Environmental cost classification As part of recording and monitoring environmental costs, it is useful to classify the costs as suggested

by Hansen and Mendoza (1999): Classification

Description

Examples

Prevention costs

Costs to prevent environmental impacts before they occur

🞂 🞂

Staff training costs Costs of measures to prevent pollution

Appraisal costs

Costs to ensure compliance with environmental standards and policies

🞂 🞂

Cost of site inspections Cost of monitoring activities

Internal failure costs

Costs incurred if an organisation has created waste but not released into the environment

🞂 🞂

Waste disposal costs Product take back costs (e.g. providing facilities to return batteries, printer cartridges etc)

External failure costs

Costs incurred if an organisation has released harmful waste into the environment

🞂 🞂

Fines Costs of cleaning up oil spills

Knowledge diagnostic Before you move on to the next phase of your studies, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you calculate and list the advantages and disadvantages of the payback period?

Can you calculate and list the advantages and disadvantages of the ARR? Do you know what a positive NPV means?

Do you know what an annuity is?

Can you calculate discount rates?

Do you know the main advantage of the NPV method?

Do you know the four types of environmental cost?

Yes/No

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Chapter 1 The fundamentals of costing INTERACTIVE QUESTION 1: SOLUTION Suitable cost unit Room/night Meal served Conference delegate Conference room/day

INTERACTIVE QUESTION 2: SOLUTION (a)

Stay the same

(b)

Fall; because the same amount of fixed cost is spread over more units

(c)

Fall; because the fixed cost per unit included within the total cost will reduce

INTERACTIVE QUESTION 3: SOLUTION (a)

Graph (1) A semi-variable cost that has both a fixed element and a variable element that changes with the level of activity

(b)

Graph (4) A fixed cost that remains constant within the relevant range

(c)

Graph (2) A variable cost that varies in direct proportion to the level of activity

(d)

Graph (3) Graph passes through origin because at zero activity no cost is incurred. Variable cost pattern until maximum cost is reached. Thereafter cost is fixed

(e)

Graph (1) A semi-variable cost that has both a fixed element and a variable element that changes with the level of activity

Management Infor mation

12 : Answers to i nteract ive questio ns

Chapter 2 Calculating unit costs (part 1) INTERACTIVE QUESTION 1: SOLUTION Cost incurred

Direct or indirect?

The salary of the garage's accountant

Indirect

The cost of heating the garage

Indirect

A can of engine oil used in the repair

Direct. This cost can be directly attributed to this particular repair.

A smear of grease used in the repair

Indirect. This cost is negligible and would not be recorded separately as a direct cost.

An overtime premium paid to the mechanic carrying Indirect. The overtime is being worked due to a out the repair generally heavy work load. This particular repair has not caused the overtime premium to be incurred.

The cost is indirect and must be shared over all the repair jobs carried out.

An idle time payment made to the mechanic while waiting for a delivery of parts for a number of jobs

Indirect. The cost cannot be identified with any particular repair job.

The wages of the supervisor overseeing the mechanic carrying out the repair

Indirect. The supervisor is overseeing all repair jobs being undertaken.

INTERACTIVE QUESTION 2: SOLUTION Quantity

Unit value (£)

Total value (£)

Balance (units)

Balance (£)

Opening Balance

100

2.00

200

100

200

03 May

Receipt

400

2.10

840

500

1040

04 May

Issue

(200)

2.10

420

300

620

09 May

Receipt

300

2.12

636

600

1256

11 May

Issue

(300)

2.12

636

(100)

2.10

210

200

410

18 May

Receipt

100

2.40

240

300

650

20 May

Issue

(100)

2.40

240

200

410

Date

Transaction

01 May

Closing inventory value =

£410

Total value of issues =

£1506 (420 + 636 + 210 + 240)

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Chapter 3 Calculating unit cost (part 2) INTERACTIVE QUESTION 1: SOLUTION Item of cost (Basis of apportionment)

Total Cost

P1

P2

S100

S101

£

£

£

£

£

Factory depreciation (floor area)

100.0

30.0

40.0

20.0

10.0

Factory repairs (floor area)

60.0

18.0

24.0

12.0

6.0

Factory office costs (number of employees)

150.0

50.0

50.0

25.0

25.0

Equipment depreciation (book value)

80.0

30.0

20.0

10.0

20.0

Equipment insurance (book value)

20.0

7.5

5.0

2.5

5.0

Heating (volume)

39.0

9.0

18.0

7.2

4.8

Lighting (floor area)

26.0

6.0

12.0

4.8

3.2

Canteen (number of employees)

90.0

30.0

30.0

15.0

15.0

Total

565.0

180.5

199.00

96.50

89.00

INTERACTIVE QUESTION 2: SOLUTION Basis

Forming

Assembly

Maint.

General

Total

£

£

£

£

£

Rent & rates

Apportionment (floor space)

8k × 6/10 = 4,800

8k × 3/10k = 2,400

8k × 0.5/10 = 400

8k × 0.5/10 = 400

8,000

Light & heat

Apportionment (floor space)

5k × 6/10 = 3,000

5k × 3/10k = 1,500

5k × 0.5/10 = 250

5k × 0.5/10 = 250

5,000

Dep’n

Apportionment (plant value)

10k × 85/100 = 8,500

10k × 7.5/100 = 750

10k × 7.5/100 = 750

Dept. expenses

Allocation

8,500

100

24,800

4,750

Total

10,000 8,600

1,400

650

31,600

Management Infor mation

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INTERACTIVE QUESTION 3: SOLUTION The relative proportions of labour hours and machine hours in each cost centre can be used to identify whether the cost centre is labour intensive or machine intensive. (a)

Forming (labour intensive)

£13,705/5,482

= £ 2.50 per direct labour hour

(b)

Machining (machine intensive)

£28,817/5,240

= £ 5.50 per machine hour

(c)

Assembly (labour intensive)

£9,978/4,989

= £ 2 per direct labour hour

INTERACTIVE QUESTION 4: SOLUTION (a) (b) (c)

Under absorbed by £475 Over absorbed by £4,735 Over absorbed by £2,300

WORKINGS Forming Overhead absorbed (£2.50 × 5,370) Overhead incurred Under absorbed overhead

£ 13,425 13,900 475

Machining Overhead absorbed (£5.50 × 6,370) Overhead incurred Over absorbed overhead

£ 35,035 30,300 4,735

Assembly Overhead absorbed (£2 × 5,400) Overhead incurred Over absorbed overhead

£ 10,800 8,500 2,300

INTERACTIVE QUESTION 5: SOLUTION Fitting kitchens

Job

Manufacturing components

Batch

Manufacturing chemicals

Process

Building offices

Contract

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Chapter 4 Marginal costing and absorption costing INTERACTIVE QUESTION 1: SOLUTION The contribution per unit is £365.99.

WORKING £ Selling price per unit Marginal cost per unit Variable material Variable labour Variable production o’head Contribution per unit

£ 1,009.99

320 192 132 644.00 365.99

Absorbed fixed overheads are not included in the calculation of marginal cost per unit or contribution per unit.

INTERACTIVE QUESTION 2: SOLUTION (a)

The absorption costing profit would be greater than the marginal costing profit.

This is because production exceeded sales, therefore the inventory level increased. Some of the fixed production overhead incurred during the period would be carried forward in the inventory value with absorption costing, thus reducing the charge to cost of sales.

(b)

The difference between the reported profits would be £2,500.

This is calculated as follows.

Difference in profit = change in inventory levels × fixed overhead absorption rate per unit = 50 units × (£10 × 5 hours) = £2,500.

Management Infor mation

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INTERACTIVE QUESTION 3: SOLUTION (a)

(i)

March £7,500 (500 units × £15) April £10,500 (700 units × £15)

(ii)

The loss reported for March will be £2,875:

Profit line

Calculation

£

Revenue

1,500 × £35

£ 52,500

Cost of sales Production cost

2,000 × £15

30,000

Add: opening inventory Less: closing inventory

– 500 × £15

(7,500) (22,500)

Variable non-production costs

£52,500 × 0.15

(7,875)

Contribution

22,125

Fixed production costs

(W1)

(15,000)

Fixed non-production costs

£120,000 / 12

(10,000)

Loss for the month

(2,875)

(W1) Fixed production costs 🞂

The fixed production overhead per unit has been calculated as £5/unit

🞂

This would have been calculated as: Budgeted fixed production overhead Budgeted units produced

(iii)

=

Budgeted fixed production overhead 36,000

= £5

🞂

Hence, the budgeted fixed production overhead for the year = £5 × 36,000 = £180,000

🞂

Hence, the fixed production overhead per month is £180,000 / 12 = £15,000

The profit reported for April will be £19,250:

Profit line

Calculation

Revenue

3,000 × £35

£

£ 105,000

Cost of sales Production cost

3,200 × £15

48,000

Add: opening inventory

From the March calculation

7,500

Less: closing inventory

700 × £15

(10,500) (45,000)

Variable non-production costs

£105,000 × 0.15

Contribution

44,250

Fixed production costs

(W1)

(15,000)

Fixed non-production costs

£120,000 / 12

(10,000)

Profit for the month

(b)

(15,750)

(i)

March April

£10,000 (500 units × £20) £14,000 (700 units × £20)

19,250

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(ii) (iii)

The production overhead for March will be under absorbed by £5,000 The production overhead for April will be over absorbed by £1,000

WORKING

Overhead absorbed (2,000 × £5) Overhead incurred (£5 × 36,000 × 1/12) Under/(over) absorbed

(iv) (v)

March £ 10,000 15,000 5,000

April £ 16,000 15,000 (1,000)

(3,200 × £5)

The loss reported for March will be £375.

The profit reported for April will be £20,250.

WORKING

Marginal costing (loss)/profit Plus increase in inventory @ £5 FOAR/unit: 500 units × £5 200 units × £5 Absorption costing (loss)/profit

March £ (2,875)

April £ 19,250

2,500 (375)

1,000 20,250

£

£

Or, using a long-form approach: March Profit line

Calculation

Revenue

1,500 × £35

52,500

Cost of sales Production cost

2,000 × £20

Add: opening inventory Less: closing inventory

40,000 –

500 × £20

(10,000) (30,000)

Under-absorption of overheads

From calculation above

(5,000)

Variable non-production costs

£52,500 × 0.15

(7,875)

Fixed non-production costs

£120,000 / 12

(10,000)

Loss for the month

(375)

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12 : Answers to i nteract ive questio ns

April Profit line

Calculation

Revenue

3,000 × £35

£

£ 105,000

Cost of sales Production cost

3,200 × £20

64,000

Add: opening inventory

From the March calculation

10,000

Less: closing inventory

700 × £20

(14,000) (60,000)

Over-absorption of overheads

From calculation above

Variable non-production costs

£105,000 × 0.15

(15,750)

Fixed non-production costs

£120,000 / 12

(10,000)

Profit for the month

Chapter 5 Pricing calculations INTERACTIVE QUESTION 1: SOLUTION Situation 1 Absolute mark-up per hour of service sold = £(60 – 40) = £20 Mark-up percentage = (20/40) × 100% = 50% Situation 2 Current absolute value of mark-up per hour of service sold = 60% × £40 = £24 Mark-up percentage required = (£24/£50) × 100% = 48%

INTERACTIVE QUESTION 2: SOLUTION (1)

Cost and selling price structure: Cost Profit Price

% 80 20 100

Price = 100/80 × £14 = £17.50 per unit (2)

Profit per unit = £27 – £18 = £9 Mark-up percentage = £9/£18 = 50% of full cost

(3)

Cost and selling price structure: Cost Profit Price

% 100.00 106.25 206.25

Full cost = (100.00/206.25) × £165 = £80 per unit

1,000

20,250

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(4)

Cost and selling price structure: % 100.00 33.33 133.33

Cost Profit Price

Percentage margin on sales price = (33.33/133.33) × 100% = 25%

INTERACTIVE QUESTION 3: SOLUTION (a)

No Division B would reject the offer as there is a negative contribution of –£5 (£30 – £20 transfer price – £15 variable cost).

(b)

(i)

No If division A has surplus capacity then no full-price external sales would be forgone as a result of transferring an additional unit to division B. Since the fixed costs are an arbitrary apportionment of costs that would be incurred anyway, the only marginal cost to be incurred within division A to provide another unit to B is £10 per unit.

From the point of view of the company as a whole, all the apportioned fixed costs can be ignored because they will be incurred anyway. The sale of a unit from B to a customer for £30 would earn a contribution of £5 as follows. £30 – £10 variable cost in A – £15 variable cost in B = £5 Therefore division B’s decision to reject the offer of £30 per unit would not be the correct decision from the company’s point of view if division A has surplus capacity.

(ii)

Yes If division A is operating at full capacity then the transfer of an additional unit to division B would mean that a full price external sale at £20 per unit is displaced, thus forgoing contribution of £10 (£20 – £10 variable cost) Therefore from the point of view of the company as a whole, the sale of a unit from B to a customer for £30 would generate a negative contribution of – £5 as follows.

Selling price Variable cost in division A Forgone contribution in division A Variable cost in division B Contribution

£ per unit 30 (10) (10) (15) (5)

Therefore division B’s decision to reject the offer of £30 per unit would be the correct decision from the company’s point of view if division A is operating at full capacity. In this situation there would be goal congruence and the manager of division B would not make a suboptimal decision. (c)

(i)

Optimum transfer price = variable cost of manufacture = £10. This would compensate division A for the incremental costs incurred in manufacture and would also lead to division B making the correct decision (to sell their product at a price of £30, making additional contribution for the company of £30 – £10 – £15 = £5).

(ii)

Optimum transfer price = market value = £20 (as we need to compensate division A for the revenue they would lose out on from making one fewer external sale to make this internal transfer).

Management Infor mation

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INTERACTIVE QUESTION 4: SOLUTION Will the manager of division B accept the offer? (a)

Will this be a goal-congruent decision for the company?

No – the buy-in price of £15 is higher than Division A’s variable cost of production by £5/unit – hence the company would be worse off by £5 per unit for every unit bought in.

Division A has spare capacity

(b) Division A has no spare capacity

Yes – currently division B pays £20 per unit to Division A, so buying in externally for £15 per unit would save Division B £5 per unit.

Yes – the buy-in price of £15 is lower than the revenue that division A could make from selling these components externally, so the company will be better off by £5 per unit.

Chapter 6 Budgeting INTERACTIVE QUESTION 1: SOLUTION Sales revenue AFTER sales quantities Closing inventory of finished goods BEFORE production volume Materials usage DOESN’T MATTER IF BEFORE/AFTER labour hours Materials usage BEFORE materials purchases

INTERACTIVE QUESTION 2: SOLUTION Sales Budget Product Sales quantity Sales price Sales value

X 2000 £100 £200,000

Z 3000 £150 £450,000

Total

£650,000

X 2000 750 (500) 2250 250 2500

Z 3000 850 (700) 3150 350 3500

Production Budget Product Sales quantity Closing Inventory Opening Inventory Production volume (good units) Allowance for 10% wastage (good units × 10/90) Total units to produce (good units × 100/90)

Material Usage Budget Material Product X Product Z Total

(2500 units * 5) (3500 units * 2)

RM11 12,500 7,000 19,500

(2500 units * 2) (3500 units * 1)

RM22 5,000 3,500 8,500

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Materials Purchase Budget Budgeted usage Closing Inventory Opening Inventory Purchase quantity Cost per unit Budgeted purchase cost

RM11 19,500 18,000 (21,000) 16,500 £5 82,500

RM22 8,500 9,000 (10,000) 7,500 £3 22,500

X 2,500 4 10,000 9 90,000

Z 3,500 8 28,000 9 252,000

Labour budget Product Production units Hours required per unit Total hours Cost per hour Total cost

Total

342,000

INTERACTIVE QUESTION 3: SOLUTION Step 1 Units 8,000 6,000 2,000

High output Low output Difference

total cost total cost Difference

£ 115,000 97,000 18,000

Step 2 Variable cost per unit £18,000/2,000 = £9

Step 3 Substituting in either the high or low volume cost:

Total cost Variable costs Fixed costs

(8,000 × £9)

High £ 115,000 72,000 43,000

Step 4 Estimated maintenance costs when output is 7,500 units: Fixed costs Variable costs Total costs

(7,500 × £9)

£ 43,000 67,500 110,500

INTERACTIVE QUESTION 4: SOLUTION The Trend equation (T) for the quarter = 12.2 + (1.3 × 3) = 16.1 Therefore, TS = T + S = 16.1 + 1.6 = 17.7

(6,000 × £9)

Low £ 97,000 54,000 43,000

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INTERACTIVE QUESTION 5: SOLUTION T = TS / S £200,000/ 0.76 = £263,158

Chapter 7 Working capital INTERACTIVE QUESTION 1: SOLUTION Cost of sales = 75% × £3,600,000 = £2,700,000 Raw materials in inventory = 150,000/(2,700,000 × 60%) × 365 Credit taken from suppliers = 130,000/(2,700,000 × 60%) × 365 WIP in inventory = 350,000/2,700,000 × 365 Finished goods in inventory = 200,000/2,700,000 × 365 Credit given to customers = 306,000/3,600,000 × 365 Number of days between payment and receipt

Days 34 (29) 47 27 31 110

* Since inventory levels are constant, annual purchases = annual usage.

INTERACTIVE QUESTION 2: SOLUTION Step 1 Calculate the annual sales revenue Receivables collection period (in days) = (Average receivables/ Sales revenue) × 365 Sales revenue

= (£90,000/30) × 365 = £1,095,000

Step 2 Calculate the cost of sales/purchases Since the opening and closing inventories are equal, the cost of sales is equal to the purchases.

Cost of sales

= £1,095,000 × 0.75 = £821,250

Step 3 Calculate the inventory balance Rate of inventory turnover = Cost of sales/Average inventory Inventory

= £821,250/18 = £45,625

Step 4 Calculate the trade payables balance Payables payment period Trade payables

= (Average payables/Purchases) × 365 = (40 × £821,250)/365 = £90,000

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Step 5 Calculate the current assets balance Current ratio Current assets

= Current assets/Current liabilities = 2.3 × £90,000 = £207,000

Step 6 Calculate the cash balance £ Total current assets Less: inventory receivables

£ 207,000

45,625 90,000 135,625 71,375

Cash balance

INTERACTIVE QUESTION 3: SOLUTION Cash budget Receipts Receipts from sales Payments Trade payables Expense payables Labour Equipment purchase Dividend Total payments Receipts less payments Opening cash balance b/f Closing cash balance c/f

February £ 55,000 (W1)

March £ 135,000 (W2)

37,500 (W3) 2,000 (W4) 3,000 18,000 – 60,500 (5,500) 1,000 (4,500)

82,500 (W3) 4,000 (W4) 5,000 – 20,000 111,500 23,500 (4,500) 19,000

WORKINGS (1) Receipts in February 75% of Feb sales (75% × £60,000) 25% of Jan sales (25% × £40,000)

£45,000 £10,000 £55,000

Receipts in March 75% of Mar sales (75% × £160,000) 25% of Feb sales (25% × £60,000)

£120,000 £15,000 £135,000

(2)

(3)

Purchases January For Jan sales (50% of £30,000) For Feb sales (50% of £45,000) For Mar sales –

February £ 15,000 22,500

£ (50% of £45,000) (50% of £120,000)

37,500

These purchases are paid for in February and March.

22,500 60,000 82,500

Management Infor mation

(4)

12 : Answers to i nteract ive questio ns

Expenses Cash expenses in January (£4,000 – £2,000) and February (£6,000 – £2,000) are paid in February and March respectively. Depreciation is not a cash item.

Notes: Steps should be taken either to ensure that an overdraft facility is available for the cash shortage at the end of February, or to defer certain payments so that the overdraft is avoided. Some payments must be made on due dates (payroll, taxation and so on) but it is possible that other payments can be delayed, depending on the requirements of the business and/or the goodwill of suppliers.

Chapter 8 Performance management INTERACTIVE QUESTION 1: SOLUTION Non-current assets

Part of divisional controllable investment

Trade receivables

Part of divisional controllable investment

Trade payables

Not part of divisional controllable investment

Inventory

Part of divisional controllable investment

INTERACTIVE QUESTION 2: SOLUTION Without Investment ROI £119,700/£570,000 £128,200/£620,000

With investment

21.0% 20.7%

RI Profit Imputed interest charge: £570,000 × 15% £620,000 × 15%

£ 119,700

£ 128,200

85,500 34,200

93,000 35,200

INTERACTIVE QUESTION 3: SOLUTION Many answers are possible. They could include: Financial 🞂 🞂 🞂

Proportion of income from legal aid Regularity of income paid in prolonged cases Net fee income from ‘No Win, No Fee’ litigation

Customer 🞂 🞂 🞂

Number of cases won Number of new clients won through recommendations Cost of key services (eg conveyancing) compared to other local firms

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Innovation and learning 🞂 🞂 🞂

Continuing Professional Development (CPD) courses attended New services offered New methods of service delivery introduced (eg online Wills)

Internal business 🞂 🞂 🞂 🞂

Time taken to process key services (eg to draft and type Wills) Administration cost (eg courier services, website maintenance) Speed of accessing archives Ease of access to legislative and case law databases

INTERACTIVE QUESTION 4: SOLUTION (a) (b) (c) (d) (e) (f) (g)

Direct material £20,400 Direct labour £23,300 Variable production overhead £10,200 Fixed production overhead £11,000 Selling and distribution overhead £9,100 Administration overhead £7,000 (i) The total expenditure variance for period 6 was £2,600 favourable (ii) The volume variance for period 6 was £15,000 adverse

WORKINGS (a)

Direct material is a variable cost of £16,000/4,000 = £4 per unit Budget cost allowance for 5,100 units = 5,100 × £4 = £20,400

(b)

Direct labour is a semi-variable cost which can be analysed using the high-low method.

High Low Change

Output Units 5,500 4,000 1,500

£ 24,500 20,000 4,500

Variable cost per unit = £4,500/1,500 = £3 Substituting in high output, fixed cost = £24,500 – (5,500 × £3) = £8,000 Budget cost allowance for 5,100 units: Variable cost = 5,100 × £3 = Fixed cost

(c)

£15,300 £8,000 £23,300

Variable production overhead per unit = £8,000/4,000 = £2 per unit Budget cost allowance for 5,100 units = 5,100 × £2 = £10,200

(d)

Fixed production overhead cost allowance is fixed at £11,000.

(e)

Selling and distribution is a semi-variable cost which can be analysed using the high-low method.

High Low Change

Output Units 5,500 4,000 1,500

Variable cost per unit = £1,500/1,500 = £1

£ 9,500 8,000 1,500

Management Infor mation

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Substituting in high output, fixed cost = £9,500 – (5,500 × £1) = £4,000 Budget cost allowance for 5,100 units: Variable cost = 5,100 × £1 Fixed cost

(f)

£5,100 £4,000 £9,100

Administration overhead cost allowance is fixed at £7,000.

Chapter 9 Standard costing and variance analysis INTERACTIVE QUESTION 1: SOLUTION The sales price variance is calculated as follows.

Sales revenue from 7,700 units should have been (× £12) but was (7,700 × £12.50) Sales price variance

£ 92,400 96,250 3,850 (F)

The variance is favourable because the actual price was higher than standard.

The sales volume variance is calculated as follows.

Budgeted sales volume Actual sales volume Sales volume variance in units

8,000 units 7,700 units 300 units (A)

Standard contribution £(12 – 7) Sales volume variance

£5 £1,500 (A)

The variance is adverse because actual sales volume was less than budgeted.

INTERACTIVE QUESTION 2: SOLUTION (a)

The material total variance This is the difference between what 1,000 units should have cost and what they did cost.

1,000 units should have cost (× £100) Did cost Material total variance

£ 100,000 98,631 1,369 (F)

The variance is favourable because the units cost less than they should have cost.

Now we can break down the material total variance into its two constituent parts: the material price variance and the material usage variance. (b)

The material price variance This is the difference between what 11,700 kgs should have cost and what 11,700 kgs did cost.

11,700 kgs of Y should have cost (× £10) Did cost Material Y price variance

£ 117,000 98,631 18,369 (F)

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The variance is favourable because the material cost less than it should have. (c)

The material usage variance This is the difference between how many kilograms of Y should have been used to produce 1,000 units of X and how many kilograms were used, valued at the standard cost per kilogram.

1,000 units should have used (× 10 kgs) Did use Usage variance in kgs Standard price per kilogram Usage variance in £

10,000 kgs 11,700 kgs 1,700 kgs (A) × £10 £17,000 (A)

The variance is adverse because more material was used than should have been used. (d)

Summary Price variance Usage variance Total variance

£ 18,369 (F) 17,000 (A) 1,369 (F)

INTERACTIVE QUESTION 3: SOLUTION (a)

The labour total variance This is the difference between what 1,000 units should have cost and what they did cost. £ 20,000 17,825 2,175 (F)

1,000 units should have cost (× £20) Did cost Labour total variance

The variance is favourable because the units cost less than they should have done.

Again we can analyse this total variance into its two constituent parts. (b)

The labour rate variance This is the difference between what 2,300 hours should have cost and what 2,300 hours did cost. £ 23,000 17,825 5,175 (F)

2,300 hours of work should have cost (× £10) Did cost Labour rate variance

The variance is favourable because the labour cost less than it should have cost. (c)

The labour efficiency variance 1,000 units of X should have taken (× 2 hours) Did take Efficiency variance in hours @ Standard rate per hour Efficiency variance in £

2,000 hrs 2,300 hrs 300 hrs (A) × £10 £3,000 (A)

The variance is adverse because more hours were worked than should have been worked.

Management Infor mation

(d)

12 : Answers to i nteract ive questio ns

Summary £ 5,175 (F) 3,000 (A) 2,175 (F)

Rate variance Efficiency variance Total variance

INTERACTIVE QUESTION 4: SOLUTION (a)

Total wages cost Adjust for variances: Labour rate Labour efficiency Standard wages cost Actual output = Total standard cost / unit standard cost = £169,200 / 72 = 2,350 units

£171,320

Total wages cost Less rate variance Standard rate for actual hours / Standard rate per hour Actual hours worked

£171,320.0 (£10,598.0) 160,722.0 ÷ £12.0 13,393.5 hrs

(£10,598) £8,478 169,200

(b)

(c)

Average actual wage rate per hour = Actual wages/actual hours = £171,320/13,393.5 = £12.79 per hour.

(d)

Number of kgs purchased and used = x x kgs should have cost (x £6) but did cost (x £5.50) Material price variance

£6.0x £5.5x £0.5x

£0.5x = £18,840; meaning x = 37,680 kgs

Chapter 10 Breakeven analysis and limiting factor analysis INTERACTIVE QUESTION 1: SOLUTION The contribution per unit is £(8 – 5) = £3 Contribution required to break even = fixed costs = £21,000 Breakeven point (BEP)

= £21,000 ÷ £3 = 7,000 units

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INTERACTIVE QUESTION 2: SOLUTION Required contribution Contribution ratio

=

£50,000 0.2

= £250,000 Number of units = £250,000 ÷ £10 = 25,000.

INTERACTIVE QUESTION 3: SOLUTION (a)

Breakeven point =

Total fixed costs Contribution per unit

=

£70,000 £(40 − 30)

= 7,000 units (b)

Margin of safety = 8,000 – 7,000 units = 1,000 units which may be expressed as 1,000 units/8,000 units × 100% = 12½% of budget (The margin of safety indicates to management that actual sales can fall short of budget by 1,000 units or 12½% before the breakeven point is reached and no profit is made).

INTERACTIVE QUESTION 4: SOLUTION Since the contribution earned in a period is literally the contribution towards fixed costs and profit, in order to achieve a certain target profit the contribution required is equal to the fixed costs plus the target profit.

Required contribution = fixed costs + profit = £68,000 + £16,000 = £84,000 Required sales can be calculated in one of two ways. (a)

Required contribution Contribution per unit

=

£84,000 £(30 – 24)

= 14,000 units, or £420,000 in revenue (b)

Required contribution Contribution ratio

= £84,000 20%

= £420,000 of revenue, or 14,000 units. £30 – £24

* Contribution ratio =

£30

= 0.2 (20%)

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INTERACTIVE QUESTION 5: SOLUTION (a)

The current unit contribution is £(18 – (8 + 2)) = £8 Current contribution (6,000 × £8) Less current fixed costs Current profit

£48,000 £40,000 £8,000

With the new machine fixed costs will increase by £10,000 to £50,000 per annum. The variable cost per unit will reduce to £(6 + 2) = £8, and the contribution per unit will increase to £10.

(b)

Required profit (as currently earned) Fixed costs Required contribution

£8,000 £50,000 £58,000

Contribution per unit Sales required to earn £8,000 profit

£10 £58,000/£10 = 5,800 units

If sales are 6,000 units Profit at 5,800 units of sale (see (a)) Contribution from sale of extra 200 units (× £10) Profit at 6,000 units of sale

£8,000 £2,000 £10,000

INTERACTIVE QUESTION 6: SOLUTION Step 1 Confirm that the limiting factor is something other than sales demand.

Kg of material per unit Sales demand Total kg needed Kg of material available Surplus

Ays 2kg 3,000 units 6,000 kg

Bes 6kg 5,000 units 30,000 kg

Ays 2 hrs 3,000 units 6,000 hrs

Bes 1 hr 5,000 units 5,000 hrs

Total

36,000 kg 38,000 kg 2,000 kg

Hence, material is not a limiting factor o n production Labour hours per unit Sales demand Labour hours needed Labour hours available Shortfall

Hence, labour is the limiting factor on production

Total

11,000 hrs 8,000 hrs 3,000 hrs

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Step 2 Identify the contribution earned by each product per unit of limiting factor, that is per labour hour worked.

Sales price Variable cost Unit contribution

Ays £ 26 20 6

Bes £ 17 13 4

Labour hours per unit Contribution per labour hour (= unit of limiting factor)

2 hrs £3

1 hr £4

Although Ays have a higher unit contribution than Bes, two Bes can be made in the time it takes to make one Ay. Because labour is in short supply it is more profitable to make Bes than Ays.

Step 3 Determine the optimum production plan. Sufficient Bes will be made to meet the full sales demand, and the remaining labour hours available will then be used to make Ays. Product Bes Ays

Demand 5,000 3,000

Product

Units

Bes Ays

5,000 1,500

Hours required 5,000 6,000

Hours available 5,000 3,000 (bal)

11,000

8,000

Hours needed

Contribution per hour £ 4 3

5,000 3,000 8,000

Priority of manufacture 1st 2nd

Total £ 20,000 9,000 29,000 20,000 9,000

Less fixed costs Profit

INTERACTIVE QUESTION 7: SOLUTION The organisation’s budget calls for 36,000 hours of machine time, if all the components are to be produced in-house. Only 24,000 hours are available, and so there is a shortfall of 12,000 hours of machine time, which is therefore a limiting factor. The shortage can be overcome by subcontracting the equivalent of 12,000 machine hours’ output to the subcontractor.

The assembly costs are not relevant costs because they are not affected by the decision.

The decision rule is to minimise the extra variable costs of subcontracting per unit of scarce resource saved (that is, per machine hour saved).

Variable cost of making Variable cost of buying Extra variable cost of buying Machine hours saved by buying Extra variable cost of buying per hour saved

S £ 20 29 9 3 hrs £3

A £ 36 40 4 2 hrs £2

T £ 24 34 10 4 hrs £2.50

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This analysis shows that it is cheaper to buy A than to buy T and it is most expensive to buy S. The priority for making the components in-house will be in the reverse order: S, then T, then A. There are enough machine hours to make all 4,000 units of S (12,000 hours) and to produce 3,000 units of T (another 12,000 hours). 12,000 hours’ production of T and A must be subcontracted.

The cost-minimising and so profit-maximising make and buy schedule is as follows.

Component Make:

S T

Buy:

T A

4,000 3,000

Unit variable cost £ 20 24

Total variable cost £ 80,000 72,000 152,000

1,000 4,000

34 40

34,000 160,000

Machine hours used/saved

Number of units

12,000 12,000 24,000

4,000 8,000 12,000 Total variable cost of components, excluding assembly costs

346,000

INTERACTIVE QUESTION 8: SOLUTION TW should manufacture 9000 units of D and 7000 units of E WORKINGS

Variable cost of making Variable cost of buying Extra variable cost of buying Raw material saved by buying Extra variable cost of buying per kg saved Priority for internal manufacture Production plan  Make

D E

(9,000  3.5 kgs) (7,000  8 kgs)

The remaining 5,000 units of E should be purchased from the sub-contractor.

D £ per unit 10 17 7 3.5 kgs £2 1

E £ per unit 15 25 10 8 kgs £1.25 2

Material used kgs 31,500 56,000 87,500

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Chapter 11 Investment appraisal techniques INTERACTIVE QUESTION 1: SOLUTION Cash flows, ie profits before depreciation should be used.

Profit after depreciation £'000 12 17 28 37 8

Year 1 2 3 4 5 (although not needed)

 Payback period

= 3 years + (

(120 − 93) 49

Depreciation £'000 12 12 12 12 12

Cash flow £'000 24 29 40 49 20

Cumulative cash flow £'000 24 53 93 142 162

× 12 months)

= 3 years 7 months

INTERACTIVE QUESTION 2: SOLUTION (a)

Using initial investment Profits before depreciation − depreciation

Average profit = =

5 (£24,000 × 5) − (£110,000 − £10,000) 5

= £4,000 p.a.

ARR (b)

=

£4,000 £110,000

× 100% = 3.6%

Using average investment =

£4,000 £(110,000 + 10,000)/ 2

× 100% = 6.7%

INTERACTIVE QUESTION 3: SOLUTION Year

Cash flow £

2

40,000

3

30,000

Total present value

Multiplied by 12% discount factor 1 (1.12)2 1 (1.12)3

Present value £

= 0.797

31,880

= 0.712

21,360 53,240

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INTERACTIVE QUESTION 4: SOLUTION Year

Cash flow £ (100,000) 60,000 80,000 40,000 30,000

0 1 2 3 4

Discount factor 15% 1.000 1/1.15 = 0.870 1/1.152 = 0.756 1/1.153 = 0.658 1/1.154 = 0.572 NPV =

Present value £ (100,000) 52,200 60,480 26,320 17,160 56,160

INTERACTIVE QUESTION 5: SOLUTION (a)

Present value

= £1,000 × annuity factor for five years at 15% = £1,000 × 3.352 = £3,352

(b)

Only the cash flows at the end of years 1 to 4 need discounting.

Present value

= £1,000 received now + (£1,000 × annuity factor for four years at 15%) = £1,000 + (£1,000 × 2.855) = £3,855

(c)

This can be solved in two possible ways. (i)

Present value

= £1,000 × (annuity factor for seven years – annuity factor for two years)

This leaves the cash flows for years 3, 4, 5, 6 and 7 being discounted. = £1,000 × (4.160 – 1.626) = £2,534 (ii)

Present value of annuity at end of year two = £1,000 × 3.352 = £3,352 Now this must be discounted again to bring it back to the present value at year 0 (now).

Present value

= £3,352 × PV factor for year 2 at 15% = £3,352 × 0.756 = £2,534

INTERACTIVE QUESTION 6: SOLUTION The first step is to calculate two net present values, both as close as possible to zero, using rates for the cost of capital which are whole numbers. Ideally one NPV should be positive and the other negative although the formula will work with two positive or two negative NPVs (extrapolation).

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Choosing rates for the cost of capital which will give an NPV close to zero (that is, rates which are close to the actual rate of return) is a hit and miss exercise, and several attempts may be needed to find satisfactory rates.

Let’s first try using a 10% discount rate:

Try 10%

Year 0 1–5 5

Cash flow £ (80,000) 20,000 10,000

PV factor 10% 1.00 3.791 0.621 NPV

PV of cash flow £ (80,000) 75,820 6,210 2,030

This is positive, which means that the internal rate of return is more than 10%. We will therefore need to increase the cost of capital to find a negative NPV - let’s try 15%: Try 15%

Year 0 1–5 5

Cash flow £ (80,000) 20,000 10,000

PV factor 12% 1.000 3.352 0.497 NPV

PV of cash flow £ (80,000) 67,040 4,970 (7,990)

This is negative, hence the internal rate of return is therefore greater than 10% (positive NPV of £2,030) but less than 15% (negative NPV of £7,990).

Note: If the first NPV is positive, choose a higher rate for the next calculation to get a negative NPV. If the first NPV is negative, choose a lower rate for the next calculation. × (15% − 10%)� = 11% So IRR = 10% + � 2,0302,030 + 7,990 If it is company policy to undertake investments which are expected to yield 10% or more, this project would be undertaken. An alternative approach would be to calculate the NPV at 10%. As it would be positive it would tell us that the IRR is greater than 10% and therefore the project should be accepted.

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