9/16/2023
MANAGEMENT
INFORMATION
VIETSOURCING TRAINING CENTER
Lecturer: Nguyen Phuong Hang, FCCA,CPA
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CHAPTER 7:CONTENT
WORKING CAPITAL
Working Capital
Performance management
Standard costing and variance analysis
Breakeven analysis and limiting factor
Investment appraisal techniques
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CHAPTER
7: WORKING
CAPITAL
MANAGEMENT
INFORMATION
Assessment format
1.5 hour computer-based
assessment
20% of the marks are allocated in
one scenario-based question.
80% are from 32 multiple choice
/multiple response questions
55% pass mark
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CHAPTER
7: WORKING
CAPITAL
MANAGEMENT
INFORMATION
Specifications grid
Syllabus area
Weighting
(%)
Costing and pricing; Ethics
25
Budgeting and forecasting
25
Performance management
25
Management decision making
25
100
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CHAPTER 7
WORKING CAPITAL
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CHAPTER 7: WORKING CAPITAL
Content
1.What is ‘working capital’?
1.Balancing liquidity and profitability
1.Assessing the liquidity position via ratios
1.The cash operating cycle
1.Managing inventory
1.Managing trade payables
1.Managing trade receivables
1.Treasury management
1.Cash budgets
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CHAPTER 7: WORKING CAPITAL
Working capital: The total of the current assets of a business less its current liabilities.
Include
inventory,
receivables, cash
and payables
Aim:
Management of
liquidity position
Net WC= Receivables +
Inventory + Cash – Payables
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CHAPTER 7: WORKING CAPITAL
Working capital: The total of the current assets of a business less its current
liabilities.
INVENTORY RECEIVABLES
PAYABLES
CASH AND BANK
BANK OVERDRAFT
CURRENT ASSETS
DIFFERENCE WORKING
CAPITAL
CURRENT LIABILITIES
EQUIRE FUNDING
PROVIDE FUNDING
CONSIDER REDUCING
CONSIDER INCREASING
LEVELS
LEVELS
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CHAPTER 7: WORKING CAPITAL
Balancing liquidity and profitability
All businesses face a trade-off between being profitable (providing a return) and being liquid .
• Cash: by ensuring that business has sufficient liquid assets (cash), it is reducing its chance of owning more
profitable assets.
• Receivables: not provide credit to customer may improve liquidity position but customers would be driven
away, revenue would fall.
• Inventory: finished goods and raw materials need to be maintained in store to satisfy customer demand 
money tied up in inventories.
• Payables: to improve cash position a business might not pay suppliers until after 2 or 3 months  risk of
alienating its suppliers.
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CHAPTER 7: WORKING CAPITAL
Balancing liquidity and profitability
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CHAPTER 7: WORKING CAPITAL
Assessing the liquidity position via ratios
Ratios
Inventory
turnover
Receivables
collection
period
Payables
payment
period
Liquidity
ratios
The ratios can be compared with previous periods or other companies in the same industry.
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CHAPTER 7: WORKING CAPITAL
Inventory turnover
Inventory turnover period is a calculation of the number of days inventory is held for
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐩𝐞𝐫𝐢𝐨𝐝
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲
x 365
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬
days
Rate of Inventory turnover is a measure of how many times inventory turns over during the trading period
𝐑𝐚𝐭𝐞 𝐨𝐟 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫
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𝐂𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬
𝐀𝐯𝐠. 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲
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CHAPTER 7: WORKING CAPITAL
Receivables collecting cost
The estimated average accounts receivable collection period is a rough measure of the average length of time it
takes for a company’s receivables to pay what they owe.
𝐀/𝐑 𝐜𝐨𝐥𝐥𝐞𝐜𝐭 𝐩𝐞𝐫𝐢𝐨𝐝
𝐀𝐯𝐠. 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬
𝐀𝐧𝐧𝐮𝐚𝐥 𝐬𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞x 365 days
Increase in A/R collection period indicates that credit control function is poorly managed or changes in credit
term.
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CHAPTER 7: WORKING CAPITAL
Payable payment cost
Account payable period provides a rough measure of the average length of time it takes a company to pay
what it owes
𝐀𝐜𝐜𝐨𝐮𝐧𝐭 𝐩𝐚𝐲𝐚𝐛𝐥𝐞 𝐩𝐚𝐲𝐦𝐞𝐧𝐭 𝐩𝐞𝐫𝐢𝐨𝐝
𝐀𝐯𝐠. 𝐏𝐚𝐲𝐚𝐛𝐥𝐞
𝐀𝐧𝐧𝐮𝐚𝐥 𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞𝐬
x 365 days
Working capital period (or average age of working capital) identifies how long it takes to convert the
purchase of inventories into cash from sales.
𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐩𝐞𝐫𝐢𝐨𝐝
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𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐜𝐚𝐩𝐢𝐭𝐚𝐥
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬
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x 365 days
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CHAPTER 7: WORKING CAPITAL
Working capital ratios
Work example
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CHAPTER 7: WORKING CAPITAL
Requirement
Calculate the division’s year-end cash balance
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CHAPTER 7: WORKING CAPITAL
Activity 1
A business has a current ratio of 2. Current assets consist of inventory $ 10 million and current liabilities of $
15 million . The company gives on average 36.5 days ' credit to its customers . Required Assuming that the
business has a zero cash balance and that there are 365 days in a year , what is the annual credit sales
revenue?
A. $ 150m
B. $ 2
C. $ 20m
D. $ 200m
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CHAPTER 7: WORKING CAPITAL
Activity 2
Forecasting
Management Co's customers pay after 73 days , on average . Next year , sales are forecast to be $ 864,000.
Required
What is the amount of receivables Management Co should forecast for next year , assuming 365 days in the
year ?
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CHAPTER 7: WORKING CAPITAL
Assess liquidity
The current ratio is the standard test of liquidity and is the ratio of current assets to current liabilities
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐫𝐚𝐭𝐢𝐨
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
The quick ratio, or acid test ratio, is the ration of current assets less inventories to current liabilities
𝐐𝐮𝐢𝐜𝐤 𝐫𝐚𝐭𝐢𝐨
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𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬
𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐢𝐞𝐬
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
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CHAPTER 7: WORKING CAPITAL
Current ratio ‐ activity
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CHAPTER 7: WORKING CAPITAL
Current ratio ‐ activity
The current ratio is close to the industry average, which appears to suggest an adequate level of
liquidity. However, when inventory is deducted from the current assets the quick ratio is below
the industry average. This business is more reliant than average on liquidating its inventory in
order to meet its current liabilities. The importance of this will depend upon how quickly the
inventory can be turned into cash, ie, the length of the cash operating cycle. Moreover, the
business has relatively little cash and its liquidity as measured by the quick ratio relies on the
quality of its receivables, ie, how likely customers are to pay their debts and how quickly they will
pay.
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CHAPTER 7: WORKING CAPITAL
Cash operating cycle
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CHAPTER 7: WORKING CAPITAL
Cash operating cycle
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CHAPTER 7: WORKING CAPITAL
Cash operating cycle ‐ Activity
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CHAPTER 7: WORKING CAPITAL
Cash operating cycle ‐ activity
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CHAPTER 7: WORKING CAPITAL
Investment in WC
Investment influenced
by:

Growth

Inflation
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CHAPTER 7: WORKING CAPITAL
Variations
between
business
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CHAPTER 7: WORKING CAPITAL
Variations between business
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CHAPTER 7: WORKING CAPITAL
Limitations of Working Capital
Balance
sheet
values at a
point of
time may
not be
typical
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CHAPTER 7: WORKING CAPITAL
Over trading
• When the business is growing:
o The cash cycle gets longer
o Sales increase
• At the introduction stage, the business:
o No trading record, so a very short credit from supplier
o No reputation, a long credit period is likely to be extended to customers
o If the business has found a ‘niche market’, rapid sales expansion may occur
• This can lead to the cycle being ‘out of balance’, so short-term financing may be necessary, sometime go
into ínolvent liquidation.
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CHAPTER 7: WORKING CAPITAL
Risk of overtrading
Managing the risk of overtrading/undercapitalization
To deal with this risk a business must either:
Plan the
introduction of
new long - term
capital
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capital
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Reduce business
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CHAPTER 7: WORKING CAPITAL
Solution to liquidity problems
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Extending the
period of
credit taken
from suppliers
Reducing the
inventoryholding period
Reducing
customers’
credit
Reducing the
production
period
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CHAPTER 7: WORKING CAPITAL
MANAGING INVENTORY
Reason for holding inventory
Ensure continuity
of production
Meet demand
Take advantage of
quantity discounts
Technical reasons,
such as maturing
whisky
Reduce ordering
costs
Seasonality of
demand or supply
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CHAPTER 7: WORKING CAPITAL
Cost associated with holding inventory
•
Purchase price
•
Holding costs
•
Reorder cost
o
Clerical and administrative cost
o
Opportunity cost of capital tied up
o
Transport cost
o
Insurance
o
Batch set-up costs
o
Risk of deterioration, obsolescence
o
Store administration
•
Shortage costs
o
Production stoppages
o
Stock out costs for finished goods
o
Emergency re-order costs
‐> The benefits of holding inventory must outweigh the costs.
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CHAPTER 7: WORKING CAPITAL
Inventory control systems
Re‐order level system: a fixed quantity will be ordered whenever inventory falls to
a pre-determined level
Periodic review system: inventory levels are reviewed at fixed time intervals to
fit in with production schedules, variable quantities are ordered as appropriate
ABC system: inventory is classified into classes A (most control effort), B (less) and
C (less still)
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CHAPTER 7: WORKING CAPITAL
Inventory control systems
Economic order quantity (EOQ)
𝐄𝐎𝐐
𝟐𝑪𝟎 𝑫
𝑪𝒉
D: demand during the period
C0: cost/order
Ch: holding cost per unit of inventory per time period
Worked example:
Material X costs £100 per kg. 2,000 kgs are to be used per year, and holding costs per kg per year are £5. Each
order placed costs £200 in administration time.
𝐸𝑂𝑄 𝑓𝑜𝑟 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙
,
= 400kg
Annual usage is 2,000 kg, so 2,000/400 = 5 orders per year will be placed
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CHAPTER 7: WORKING CAPITAL
EOQ Model
Assumptions:
• Purchase price per unit is constant
• Constant demand
• No risk of stock - outs
• Holding cost depends on average level
of inventory
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CHAPTER 7: WORKING CAPITAL
EOQ Model
Assumptions:
• Purchase price per unit is constant
• Constant demand
• No risk of stock - outs
• Holding cost depends on average level
of inventory
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CHAPTER 7: WORKING CAPITAL
Activity : EOQ
Firm X faces regular demand of 150 units per month. It orders from its supplier at a
purchase cost per unit of $ 25. Each order costs $ 32, and annual holding cost is $ 4.50 per
unit.
Required
1. Calculate the economic order quantity, and the average inventory level.
2. Calculate total inventory - related cost at this economic order quantity.
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CHAPTER 7: WORKING CAPITAL
Inventory control systems
• Just‐in‐time (JIT): production and purchasing are linked closely to sales demand, negligible
inventories need to be held
• Perpetual inventory methods: where perpetual inventory records are kept
• Other ways to manage inventory:
o
Sub-contract (outsource) non-core processes
o
Obtain progress payments from customers
o
Reduce the number of product line
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CHAPTER 7: WORKING CAPITAL
MANAGING PAYABLE
• Payables may be used as a source of short-term finance. If a company delays
payment by a further month then they now have a further months use of the cash.
• However, delaying payment may lose the company it’s credit status with the
supplier and could result in supplies being stopped.
• Additionally, the company could lose the benefit of any settlement discount
offered by the supplier for early payment.
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CHAPTER 7: WORKING CAPITAL
MANAGING PAYABLE
• Advantages of trade credit
o
Convenient and informal
o
Not qualify for credit from a financial institution.
o
Subsidy or sales promotion device offered by the seller
o
Overcome unexpected cash flow crises in short term
• Disadvantages:
o
Credit status may be lost
o
Supplier may raise prices
o
The buyer will lose any cash discount
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CHAPTER 7: WORKING CAPITAL
MANAGING PAYABLE
Business should
Consider switching suppliers if better credit terms are available
Negotiate better terms for buying large quantities
Reconcile statements
Pay only on completion of correct delivery
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CHAPTER 7: WORKING CAPITAL
MANAGING PAYABLE
Evaluating discounts
• If a supplier offers a discount for the early payment of debts, the evaluation of the decision whether to
accept the discount is the mirror image of the evaluation of the decision whether to offer a discount to
customers.
• Accepting early settlement discounts from a supplier will result in a benefit (the discount) but will result in
lower payables which will incur a cost to the company by increasing the cost of the interest charged on an
overdraft, since money is being paid to suppliers earlier.
• This can be assessed by comparing the benefit of the discount to the cost of higher finance costs associated
with lower payables.
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CHAPTER 7: WORKING CAPITAL
Activity
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CHAPTER 7: WORKING CAPITAL
MANAGING RECEIVABLES
• Ideal level of trade receivables requires trade-off between:
o The cost of extending credit to customers: financing costs, irrecoverable debts and admin cost
o The benefits of granting credit: sales increase
• Receivable management includes:
o Credit control and collection policies
o Financing trade receivables
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CHAPTER 7: WORKING CAPITAL
Credit control and collection policies
• Credit control and collection policies should be set at board level
• Credit terms and settlement discounts: depend on external factors, such as, competition, industry norms,
customer size, etc
• Credit rating: indicates risk of bad debts
o Assessment of ability of the customer to meet the liabilities
o Assessment of financial statements
o Use of credit rating agencies
o Analysis of on going trading experience
o Exchange information from credit managers
o Credit limits set on a particular customer
o Trade an bank references
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CHAPTER 7: WORKING CAPITAL
Credit terms and settlement discounts
Credit terms will be influenced largely by trade custom which may, for example, be payment within 60 days.
Settlement discounts are again influenced largely by custom and practice within the industry.
Worked example: Settlement discount
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 2 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.
Requirement
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?
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CHAPTER 7: WORKING CAPITAL
Worked example ‐ Solution
Sales
Cash received
Month 1
£
Current policy
Sales M1
Sales M2
Total cash
Proposed policy
Sales M1
Sales M2
£
25%
5,000
0
5,000
£
70%
14,000
5,000
19,000
£
5%
1,000
0
1,000
50% × 97%
12,125
0
12,125
44%
11,000
12,125
23,125
6%
1,500
0
1,500
20,000
20,000
25,000
25,000
Month 2 Irrecoverable debts
Discount
allowed
£
0
0
0
50% × 3%
375
0
375
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.
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CHAPTER 7: WORKING CAPITAL
Activity: extended credit terms
Greedy Co is considering a proposal to change its credit policy from allowing
debtors credit of two months to credit of three months. Sales are currently $
600,000 p.a. and as a result of the proposed change will increase by 15 %. The
contribution/sales ratio is 20 % and the cost of capital is 10 %.
Required
Should the proposed change be made ?
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CHAPTER 7: WORKING CAPITAL
Financing trade receivables
• Invoice discounting
o Involving selling the invoices to a discounting company for a cash sum, then repaying the discounter
when debtor pays the invoice
o The company retains full responsibility for sales ledger, credit control and collection functions.
• Receivable factoring: contains three closely integrated elements
o Accounting and collection: factor will pay as customer or after an agreed settlement period. Factor
maintains the sales ledger accounting function.
o Credit control: Factor is responsible for chasing the customers
 Recourse factoring means that any bad debts are passed back to the client company
 Non-recourse factoring provides 100% bad debts insurance, the client company does not suffer from
the cost of bad debts
o Financing against sales: Factor advances, say, 80% of the value of sales immediately on invoicing.
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CHAPTER 7: WORKING CAPITAL
Activity:Factor with finance
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CHAPTER 7: WORKING CAPITAL
Activity :Factor with finance ‐ answer
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CHAPTER 7: WORKING CAPITAL
Good practice in receivable management
• Look after key accounts: 20% of customers represent 80% of the debts
• Manage time scales:
o Reduce the time between the placement of the order and the receipt of goods by the customer
 Encourage customers to switch to the quickest method of ordering such as internet
ordering
 Make sure orders are taken accurately
 Clear orders for creditworthiness as soon as possible
 Make the dispatch as quick as possible
 Use efficient carriers
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CHAPTER 7: WORKING CAPITAL
Good practice in receivable management
• Manage time scales (Cont’d):
o Reduce the time taken to bill your customer:
 Issue invoices on time
 Ensure disrupted invoices are agreed as soon as possible
 Issue statements promptly each month
 Be flexible, and invoice to meet the customer’s requirements
o Reduce time taken to collect debts:
 Aging analysis
 Issue credit not promptly
 Pay commission to salesperson
 Set targets for receivable days
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CHAPTER 7: WORKING CAPITAL
Trade credit insurance
• Trade credit insurance insures a
business against the possible default
and insolvency of its credit customers
and political risk.
• Credit insurance means a business can:
• Insure all part of its A/R against
default by a customer
• Include ‘first loss’ on its accounts to
be insured
• Be insured only up to ceiling
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CHAPTER 7: WORKING CAPITAL
Customer ageing
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CHAPTER 7: WORKING CAPITAL
Treasury management
Trade-off: cost of holding cash vs. cost of running out of cash
Influences on cash balances
Aim of good cash management
Short-term finance
Investing surplus funds
Transmission of cash
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CHAPTER 7: WORKING CAPITAL
Trade‐off: cost of holding vs. cost of running out of cash
• The basic trade-off: cost of holding cash vs. cost of running out of cash
o Cost of holding cash: opportunity cost
o Cost of running out of cash:
 Loss of settlement discounts
 Loss of supplier goodwill
 Poor industry relation if wage payments are delayed
 Bankrupt risk
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CHAPTER 7: WORKING CAPITAL
Influences on cash balances
How much a business wish to hold cash:
Transactions
motive: daily
payments
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Finance motive:
repayment of
loans, purchase
of PPE
Precautionary
motive: pay for
contingencies
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Investment
motive: take
opportunities
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CHAPTER 7: WORKING CAPITAL
Aim of good cash management
Accurate cash
budgeting
Aim of good cash management is to have the
right amount of cash available at the right time
Cost-efficient
cash
transmission
Planning shortterm finance
Planning
investment of
surpluses
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CHAPTER 7: WORKING CAPITAL
Short‐term finance
Receivable factoring
and invoice
discounting
Operating
leases
Bank
overdrafts
Short-term bank
loans
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CHAPTER 7: WORKING CAPITAL
Investing surplus funds
• Factors to be considered:
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Amount of
funds
Length of
time
Withdrawal
time, and
penalties
Risk and
return of
investment
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CHAPTER 7: WORKING CAPITAL
Cash surpluses invesment
Treasury bills
Short - term government IOUS , can be sold when
needed.
Term deposits
Fixed period deposits.
Certificates of deposit
Issued by banks , entitle the holder to interest plus
principal , can be sold when needed.
Commercial paper
Short - term IOUs issued by companies ,
unsecured.
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CHAPTER 7: WORKING CAPITAL
Cash budgets
• A cash budget is a detailed budget of cash inflows and out flows incorporating both revenue and
capital items.
• Usefulness of cash budget
Cash control
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Can give
managers
indication of
problems
Cash affects all
plans
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CHAPTER 7: WORKING CAPITAL
Potential cash positions
Cash position
Appropriate management action
Short-term surplus
- Pay suppliers early to obtain discount
- Allow receivable increase to increase sales
- Make short-term investments
Short-term shortfall
- Increase accounts payables
- Collect receivables
- Arrange overdraft
Long-term surplus
- Make long-term investments
- Expand
- Diversify
- Replace/update PPE
Long-term shortfall
- Raise long-term finance
- Consider shutdown/divestment
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CHAPTER 7: WORKING CAPITAL
Worked example: Preparing a cash budget
Penny operates a retail business. Purchases are sold at cost plus 33 1/3%.
Budgeted sales
Labour cost Expenses incurred
in month
in month
in month
£
£
£
January
40,000
3,000
4,000
February
60,000
3,000
6,000
March
160,000
5,000
7,000
April
120,000
4,000
7,000
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CHAPTER 7: WORKING CAPITAL
Cash budgets
Worked example: Preparing a cash budget
(1) 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.
(2) 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.
(3) Expenses include a monthly depreciation charge of £2,000.
(4) (i) 75% of sales are for cash.
(ii) 25% of sales are on one month’s credit.
(5) 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
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CHAPTER 7: WORKING CAPITAL
Worked example: Preparing a cash budget ‐ 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
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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
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CHAPTER 7: WORKING CAPITAL
Worked example: Preparing a cash budget ‐ Solution
WORKING
(1)
Receipts in February
75% of Feb sales (75% £60,000)
25% of Jan sales (25% £40,000)
Receipts in March
75% of Mar sales (75% £160,000)
25% of Feb sales (25% £60,000)
£
45,000
10,000
55,000
£
120,000
15,000
135,000
(2)
(3) Purchase
For Jan sales
For Feb sales
For Mar sales
January
February
(50% of £30,000)
(50% of £45,000)
£
15,000
22,500
–
37,500
£
(50% of £45,000)
(50% of £120,000)
22,500
60,000
82,500
These purchases are paid for in February and March.
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CHAPTER 7: WORKING CAPITAL
Worked example: Preparing a cash budget ‐ Solution
WORKING
(4)
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.
Note: 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.
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CHAPTER 7: WORKING CAPITAL
Cash budgets
Interactive question
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CHAPTER 7: WORKING CAPITAL
Interactive question 6: Cash budget
You are presented with the budgeted data shown in Annex A for the period November 20X1 to June 20X2 by
your firm. It has been extracted from the other functional budgets that have been prepared. You are also told
the following.
(1) Sales are 40% cash, 60% credit. Credit sales are paid two months after the month of sale.
(2) Purchases are paid in the month following purchase.
(3) 75% of wages are paid in the current month and 25% the following month.
(4) Overheads are paid the month after they are incurred. The overhead figures include monthly depreciation
of £2,000.
(5) Dividends are paid three months after they are declared.
(6) Capital expenditure is paid two months after it is incurred.
(7) The opening cash balance is £15,000.
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CHAPTER 7: WORKING CAPITAL
Interactive question 6: Cash budget
Requirement
Use the following framework to prepare the cash budget. You should make an entry in every box in the cash
budget. Enter a zero or a dash where applicable. Do not leave any boxes blank.
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CHAPTER 8
PERFORMANCE MANAGEMENT
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CHAPTER 8: PERFORMANCE MANAGEMENT
Content
Performance evaluation
Responsibility centres
Performance measures
The balanced scorecard
Budgetary control
Data bias and professional skepticism
Sustainability
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CHAPTER 8: PERFORMANCE MANAGEMENT
Feedback control
The term ‘feedback’ is used to describe both the process of reporting back control information to
management and control information itself.
Plan, target or
budget
Feedback loop in the control cycle
Compare
actual result
with plan
Feedback of
information
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Input resources
Operations
Control action
Output
Measure
outputs
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CHAPTER 8: PERFORMANCE MANAGEMENT
Control cycle
• Step 1: Plans and targets are set for the future
• Step 2: Plans are put into operation
• Step 3: Actual results are recorded and analysed
• Step 4: Information about actual results is fed back
• Step 5: The feedback is used by management to compare actual results with plans or targets
• Step 6: By comparing actual and planned results, management can:
o Take control action
o Can decide to do nothing
o Can alter the plan or target
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CHAPTER 8: PERFORMANCE MANAGEMENT
Control sales ‐ example
• Step 1: A sales budget or plan is prepared for the year.
• Step 2: Management organises the business’s resources to achieve the budget targets.
• Step 3: At the end of each month, actual results are reported back to management.
• Step 4: Managers compare actual results against the plan.
• Step 5: Where necessary, they take corrective action to adjust the workings of the system, probably by
amending the inputs to the system.
o Sales people might be asked to work longer hours
o More money might be spent on advertising
o Some new price discounts might be decided
o Delivery periods to customers might be reduced by increasing output
Where appropriate the sales plan may be revised, up or down.
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CHAPTER 8: PERFORMANCE MANAGEMENT
Features of effective feedback
• Clear and comprehensive
• Apply ‘exception principle’: highlight the significant differences between target and the actual results for
investigation
• Controllable costs and revenues should be separately identified
• Report should be produced on a regular basis
• Should be made in timely fashion
• Feedback information should be sufficiently accurate
• Irrelevant detail should be excluded
• Report should be communicated to the manager who has responsibility and authority to act on the information
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CHAPTER 8: PERFORMANCE MANAGEMENT
Behavioral impact of performance measurement
Budget
constrained
• Actual cost vs. budget
Profit
conscious
• Ability to increase the
general effectiveness in
relation to long-term
purposes
Nonaccounting
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• The budgetary
information is
unimportant in
performance evaluation
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CHAPTER 8: PERFORMANCE MANAGEMENT
Behavioral impact of performance measurement
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CHAPTER 8: PERFORMANCE MANAGEMENT
Summary of evaluation styles
Budget
constrained
Profit
conscious
Non‐
accounting
Involvement with costs
HIGH
HIGH
LOW
Job-related tension
HIGH
MEDIUM
MEDIUM
EXTENSIVE
LITTLE
LITTLE
Relation with supervisor
POOR
GOOD
GOOD
Relation with colleagues
POOR
GOOD
GOOD
Manipulation of the accounting
reports
Budget bias or manipulation of accounting reports is more likely to occur if the manager is under pressure to
achieve short-term budget targets
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CHAPTER 8: PERFORMANCE MANAGEMENT
Budget bias
• Manager deliberately overestimates costs and/or underestimates revenues, so that they will not
be blamed in the future for overspending and/or poor results.
• In controlling actual operations, managers might ensure that their spending rises to meet their
inflated budget, otherwise they will be ‘blamed’ for careless budgeting.
• Because inefficiency and slack are allowed for in budgets, achieving a budget target means only
that costs have remained within the accepted levels of inefficient spending.
• After a run of mediocre results, some managers deliberately overstate revenues and understate
cost estimates, no doubt feeling the need to make an immediate favourable impact by promising
better performance in the future. They may merely delay problems, however, as the managers
may well be censured when they fail to hit these optimistic targets.
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CHAPTER 8: PERFORMANCE MANAGEMENT
Responsibility centres
• A responsibility centre is a function or department of an organisation that is headed by a
manager who has direct responsibility for its performance
o Cost centres
o Profit centres
o Revenue centres
o Investment centres
• Responsibility accounting is a system of accounting that segregates revenue and costs into
areas of personal responsibility in order to monitor and assess the performance of each part of
an organisation
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CHAPTER 8: PERFORMANCE MANAGEMENT
Divisionalization
A large organisation can be structured in one of two ways:
functionally (all
activities
of
a
similar type within
a company, such as
production, sales,
research, are under
the control of the
appropriate
departmental
head)
divisionally (split
into divisions in
accordance with
the products or
services made or
provided).
Divisional structure will lead to decentralisation of the decision-making process.
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CHAPTER 8: PERFORMANCE MANAGEMENT
Factors affecting the degree of decentralisation
Management
style
Size of the
organization
Ability of
management
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Extent of
activity
diversification
Speed of
technological
advancement
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Effectiveness of
communication
Geographical
locations
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CHAPTER 8: PERFORMANCE MANAGEMENT
Advantage vs. Disadvantage of Divisionalisation (decentralisation)
Advantages
Disadvantages
Frees top management/senior managers in detail
Difficult to coordinate activities of the organisation
involvement
Improve the quality of decisions
Lack of goal congruence in decision making
Make decision quickly
Lose control from senior managers
Motivate divisional managers
Difficult to evaluate performance of managers and
their area of responsibility
Training for future top management
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Duplication of some roles (i.e. administrative)
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CHAPTER 8: PERFORMANCE MANAGEMENT
Responsibility centre summary
Type of
responsibility
centre
Cost centre
Revenue centre
Profit centre
Investment centre
Manager has control over
Principal performance
measures
• Controllable costs
• Variance analysis
• Efficiency measures
• Revenue only
• Revenues
• Controllable costs
• Sales prices (including transfer
prices)
• Profit
• Profit margins
• Controllable costs
• Sales prices (including transfer
prices)
• Output volumes
• Investment in non-current assets
and working capital
• Return on investment
• Residual income
• Other financial ratios
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CHAPTER 8: PERFORMANCE MANAGEMENT
Cost centre
• A cost centre acts as a collecting place for certain costs before they are analysed further
• Costs of the cost centres should be divided into:
o Attributable costs (direct responsible)
o Shared costs (indirect responsible)
• Performance is measured by cost variances (differences between actual and budgeted costs)
• Example:
o Maintenance division;
o Accounting division;
o Production divisions;
o Marketing department;
o …
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CHAPTER 8: PERFORMANCE MANAGEMENT
Revenue and Profit centre
• The manager of a revenue centre is responsible for raising revenue but has no responsibility for
forecasting or controlling costs.
o Example: Sales centre
• A profit centre is any unit of an organisation to which both revenue and costs are assigned, so that the
profitability of the unit may be measured.
o Key performance measure of a profit centre is Profit
o Example:
 Sale persons
 Sale department
A profit centre’s performance report, in the same way as that for a
cost centre, would identify separately the controllable and noncontrollable costs as well as the controllable and non - controllable
revenues.
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CHAPTER 8: PERFORMANCE MANAGEMENT
Revenue and
Profit centre
The variances
(differences
between budgeted
and actual
results) could be
analysed in
further detail for
the profit centre
manager.
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CHAPTER 8: PERFORMANCE MANAGEMENT
Investment centre
• An investment centre is a profit centre whose performance is measured by its return on capital employed.
o Profit/Sales ratios
o Asset turnover ratios
o Cost/Sales ratios
• Example:
•
Investment division
•
A subsidiaries or branches (standing at parent company)
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CHAPTER 8: PERFORMANCE MANAGEMENT
Investment centre
Interactive question 1: Controllable investment in division
The manager of division D has complete autonomy regarding the purchase and use of noncurrent 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.
Requirement
Classify 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.
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CHAPTER 8: PERFORMANCE MANAGEMENT
Share service centres (SSC)
Shared service centres consolidate the transaction-processing activities of many operations
within a company
Advantages:
• Reduce headcount
• Reduction in premises and other overhead costs
• Share knowledge to improve quality of service
• Standard approach adopted across the organization
Disadvantages:
• Loss of business specific knowledge
• Remove from decision making
• Weakened relationship
• Cost inefficiencies
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CHAPTER 8: PERFORMANCE MANAGEMENT
Share service centres in practical
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CHAPTER 8: PERFORMANCE MANAGEMENT
Cloud Accounting
• Cloud computing: is a model for enabling ubiquitous, convenient, on-demand network
access to a shared pool of configurable computing resources
• Cloud accounting: An application of cloud computing where accountancy software is
provided in the cloud by a service provider
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CHAPTER 8: PERFORMANCE MANAGEMENT
Benefits of cloud accounting
• Accounting information can be accessed from anywhere, at any time
• The security systems in place will often be better than a small business can provide
• The software updates are managed by the cloud accounting suppliers
• Applications are usually rented than purchased.
• Overhead costs can be reduced
• No worry about the PC’s powerfulness
• Collaboration between users is easier
• No need to upgrade servers
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CHAPTER 8: PERFORMANCE MANAGEMENT
Risks of cloud accounting
• The supplier could fail and so a contingency plan is required
• Operations could be hampered if there is a problem with internet access
• Risk of security breaches
• Unannounced changes or upgrades to software could be disruptive.
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CHAPTER 8: PERFORMANCE MANAGEMENT
Performance measures
• Performance measures should promote goal congruence
• Link to responsibility centre
• Pursuit longer term objectives
• Measurement needs resources
• Performance must be measured in relation to something, otherwise measurement is meaningless. Overall
performance should be measured against the objectives of the organisation and the plans that result from
those objectives.
• Short and long-term achievement should be measured.
• Measures should be fair.
• A variety of measures should be used.
• Realistic estimates may be required for measures to be employed.
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CHAPTER 8: PERFORMANCE MANAGEMENT
Performance measures
Performance measurement and
control
Ratio analysis
NFPIS
• Balanced scorecard
− Customer
− Internal
− Learning & growth
− Financial
• Building block
− Dimensions
− Standards
− rewards
• Profitability – ROCE,
asset turnover,
gross/net profit margin
• Liquidity – current and
acid test ratio
• Risk – operational and
financial gearing,
dividend and interest
cover. FPIs
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Behavioral & external
considerations
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• Short-termism
• Manipulation of results
• Participation in target
setting
• Achievability of targets
• Stakeholders
• Market conditions and
competitors
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CHAPTER 8: PERFORMANCE MANAGEMENT
Performance measures for responsibility centres
• Performance measures for a cost centre:
o Cost variances
o Cost per unit
o Cost per employee
• Performance measures for a profit centre:
• Performance measures for a revenue centre:
o Revenue variances
o Gross and operating profit margin
• Performance measures for an investment centre:
o Revenue earned per employee
o ROCE and RI
o Percentage market share achieved
o Growth in revenue
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CHAPTER 8: PERFORMANCE MANAGEMENT
Performance measures for responsibility centres
𝐑𝐎𝐈
𝐂𝐨𝐧𝐭𝐫𝐨𝐥𝐥𝐚𝐛𝐥𝐞 𝐩𝐫𝐨𝐟𝐢𝐭 𝐛𝐞𝐟𝐨𝐫𝐞 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐧𝐝 𝐭𝐚𝐱
𝐂𝐨𝐧𝐭𝐫𝐨𝐥𝐥𝐚𝐛𝐥𝐞 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝
(%)
Advantages of ROI
Disadvantages of ROI
• Relative measure (%), therefore aids
comparisons between divisions of
different sizes
• ROI increases as assets get older if NBVs are used, thus
giving managers an incentive to hang on to possibly
inefficient obsolete machines
• Used externally (ROCE) and therefore
understood by users
• May lead to dysfunctional decision making e.g. a
division with a current ROI of 30% would not wish to
accept a project offering an ROI of 25% as this would
dilute its current figure
• Encourages good use of existing capital
resources
• It can be broken down into secondary
ratios for more detailed analysis
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• Different accounting policies can confuse comparisons
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CHAPTER 8: PERFORMANCE MANAGEMENT
Performance measures for responsibility centres
Worked example: The effect of changing the capital employed base
An asset costs £100,000, has a life of four years, and its scrap value is nil. The asset generates annual
cash flows of £34,000 and straight-line depreciation is used.
Requirement
Complete the following:
(1) Calculate annual ROI using opening carrying amount (ie, depreciation is deducted from the
asset value).
(2) Calculate annual ROI using historical cost (ie, no depreciation is deducted from the asset value).
(3) Comment on any problems identified by these calculations
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CHAPTER 8: PERFORMANCE MANAGEMENT
Performance measures for responsibility centres
Worked example ‐ answer
ROI using opening carrying amount
Year 1: (34 – 25) ÷ 100 = 9%
Year 2: (34 – 25) ÷ 75 = 12%
Year 3: (34 – 25) ÷ 50 = 18%
Year 4: (34 – 25) ÷ 25 = 36%
ROI improves despite constant annual profits. Consequently, divisional managers may hold assets for
too long.
ROI using historical cost
Years 1–4: (34 – 25) ÷ 100 = 9%
ROI using historical cost overcomes the increasing return problem of using the carrying amount.
However, it is not perfect
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CHAPTER 8: PERFORMANCE MANAGEMENT
Performance measures for responsibility centres
ROI and goal congruence In certain circumstances the use of ROI as a performance measure might
not lead to goal congruent decisions.
Worked example: ROI and goal congruence
Data for an investment centre are as follows.
Requirement:
Would the division manager accept a project requiring capital of £100,000 and generating profits
of £25,000, if the manager were paid a bonus based on ROI?
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CHAPTER 8: PERFORMANCE MANAGEMENT
Performance measures for responsibility centres
Worked example: ROI and goal congruence
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CHAPTER 8: PERFORMANCE MANAGEMENT
Residual income (RI)
RI = Pre tax controllable profits – imputed charge for controllable invested capital
Advantages of RI
Disadvantages of RI
• Reduces the problem of rejecting projects with ROIs
• Does
greater than the group target but less than the division’s
not
facilitate
comparisons
between divisions of different sizes
current ROI
• Possible to use different rates of interest for different
types of business (different risks)
• Cost of financing a division is brought home to divisional
managers
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CHAPTER 8: PERFORMANCE MANAGEMENT
Residual income (RI)
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CHAPTER 8: PERFORMANCE MANAGEMENT
Residual income (RI)
The advantages and disadvantages of RI compared with ROI:
(a) Residual income will increase when investments earning above the cost of capital are
undertaken and investments earning below the cost of capital are eliminated.
(b) Residual income is more flexible since a different cost of capital can be applied to investments
with different risk characteristics.
The disadvantages of RI are that it does not facilitate comparisons between investment centres nor
does it relate the size of a centre’s income to the size of the investment.
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CHAPTER 8: PERFORMANCE MANAGEMENT
Non‐financial performance indicators
• Financial performance appraisal often reveals the ultimate effects of operational factors and
decisions but non-financial indicators are needed to monitor causes.
• Critical success factors financial often nonfinancial
• Stakeholder objectives may also be nonfinancial
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CHAPTER 8: PERFORMANCE MANAGEMENT
Increase use of NFPIs ‐ reason
Concentration on
too few variables
Lack of information
on quality
Changes in cost
structures
Changes in
competitive
environment
Changes in
manufacturing
environment
Better for future
prospects
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CHAPTER 8: PERFORMANCE MANAGEMENT
The balanced scorecard (Kaplan and Norton)
Financial perspective
How do we look to
shareholders and
lenders?
Customer
perspective
How do customers
see us?
Innovation &
learning
Can we continue to
improve and create
value?
VISION
& STRATEGY
Internal business
processes
What must we excel
at?
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BSC’s perspectives and measures
FINANCIAL PERSPECTIVE
Goals
Measures
Surive
Cash flow
Succeed
Quarterly sales growth
Operating income by division
Prosper
Increase market share and ROE
INTERNAL BUSINESS PERSPECTIVE
Goals
Measures
Design productivity
Engineering efficiency
New product
introduction
Actual production schedule vs
plan
Manufacturing
excellence
Cycle time
Unit cost
Yield
INNOVATION & LEARNING PERSPECTIVE
Goals
Measures
Technology leadership Time to develop next generation
Manufacturing
learning
Process time to maturity
Product focus
Percentage of product that equal 80% of
sales
Product & service
% revenues generated by new products/
services
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CUSTOMER PERSPECTIVE
Goals
Measures
Price
Compare with the prices of
competitors
Responsive
supply
On-time delivery (defined by
customer)
Customer
partnership
Number of cooperative
engineering efforts, repeat
purchase
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CHAPTER 8: PERFORMANCE MANAGEMENT
BSC’s perspectives and measures
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CHAPTER 8: PERFORMANCE MANAGEMENT
BSC’s perspectives and measures
Problem
Explanation
Conflicting
measures
Some measures in the scorecard such as research funding and cost reduction may
naturally conflict. It is often difficult to determine the balance which will achieve the
best results.
Selecting
measures
Not only do appropriate measures have to be devised but the number of measures
used must be agreed. Care must be taken that the impact of the results is not lost in a
sea of information.
Expertise
Measurement is only useful if it initiates appropriate action. Non-financial managers
may have difficulty with the usual profit measures. With more measures to consider
this problem will be compounded.
Interpretation
Even a financially-trained manager may have difficulty in putting the figures into an
overall perspective.
Too many
measures
The ultimate objective for commercial organisations is to maximise profits or
shareholder wealth. Other targets should offer a guide to achieving this objective and
not become an end in themselves.
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CHAPTER 8: PERFORMANCE MANAGEMENT
Balanced Scorecard
• Broad outlook
• Internal & external matters
Features
• Financial & non-financial
• Identifies customer needs
• Specific to company
Development
• Can be created at all levels of management
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CHAPTER 8: PERFORMANCE MANAGEMENT
Advantages and disadvantages of BSC
Advantages:
All four
perspectives
considered
by managers
Consistency
between
objectives,
control
systems and
staff
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Disadvantages:
Conflict
measures
Selecting
measures
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Expertise
Interpretati
on
Too many
measures
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CHAPTER 8: PERFORMANCE MANAGEMENT
Budgetary control
• Budgetary control: comparison of the actual results with a budget prepared for a different activity level
might not be valid for control purposes.
• Fixed budget
o Fixed budgets remain unchanged regardless of the level of activity
o prepared before beginning of budget period
o budget volumes and $
• Flexible budget
o changes as volume of activity changes
o used to ascertain the budget cost allowance, or flexed budget
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CHAPTER 8: PERFORMANCE MANAGEMENT
Purpose of flexible budgets
To cope
with
different
activity
levels
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CHAPTER 8: PERFORMANCE MANAGEMENT
Flexible budgets
Step 1: Determine cost
behaviour (fixed or
variable)
Step 2: Calculate the
budget cost allowance for
each cost item
• Budget cost allowance =
Budgeted fixed cost + (number
of units x variable cost per
unit)
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CHAPTER 8: PERFORMANCE MANAGEMENT
Flexible budgets ‐ Correct approach to control
The correct approach to control is as follows:
Identify fixed and
variable costs
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Produce a flexible
budget based on the
actual activity level
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CHAPTER 8: PERFORMANCE MANAGEMENT
Flexible budgets
Worked example
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CHAPTER 8: PERFORMANCE MANAGEMENT
Data bias and professional scepticism in performance management
• Various types of data bias can appear in performance management.
• Professional scepticism must be applied to identify data bias.
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CHAPTER 8: PERFORMANCE MANAGEMENT
Sustainability and ESG reporting
Monitoring sustainability
• Identifying the key sustainability issues for the business and the factors that drive them
• Setting targets and standards for sustainability objectives
• Monitoring progress towards sustainability objectives in terms of both processes and
outcomes.
o Process – is the organisation doing the things that it said that it would, to implement
sustainability initiatives?
o Outcome – having implemented initiatives, is the organisation achieving the outcomes
towards which it is striving?
• Reporting progress and evaluating the implications for future decision making and performance
(feedback).
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CHAPTER 8: PERFORMANCE MANAGEMENT
Sustainability and ESG reporting
Performance indicators that could be used to measure sustainability
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CHAPTER 8: PERFORMANCE MANAGEMENT
Sustainability and ESG reporting
Performance indicators that could be used to measure sustainability
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CHAPTER 8: PERFORMANCE MANAGEMENT
Sustainability and ESG reporting
Performance indicators that could be used to measure sustainability
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CHAPTER 8: PERFORMANCE MANAGEMENT
Sustainability and
ESG reporting
Performance indicators
that could be used to
measure sustainability
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CHAPTER 9
STANDARD COSTING AND
VARIANCE ANALYSIS
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Content
Standard costing and standard costs
Cost variances
Sales variances and operating statements
Interpreting variances and deriving actual data from variance detail
Data bias in variance analysis
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Standard costing
A pre-determination of what a product is expected to
cost under specific working conditions.
Standard costing is a control technique that reports
variances by comparing actual loss to pre-set
standards so facilitating management by exception
(CIMA definition).
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
What is a standard cost?
STANDARD COST CARD
• A standard cost is an estimated
Product: the X, No 12345
Cost
unit cost
Requirement
Direct materials
• The standard cost is set out on
a standard cost card
$
A
$2.00 per kg
6 kgs
12.00
B
$3.00 per kg
2 kgs
6.00
C
$4.00 per kg
1 kg
4.00
Other
$
2.00
24.00
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
What is a standard cost?
STANDARD COST CARD
Product: the X, No 12345
Cost
Requirement
Direct labour
Grade I
$
$4.00 per hour
3 hrs
12.00
$5.40 per hour
5 hrs
27.00
$
39.00
Variable production
overheads
$1.00 per hour
8 hrs
8.00
Fixed production overheads $3.00 per hour
8 hrs
24.00
Standard full cost of
production
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95.00
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Ideal standards
• a standard which can be attained under perfect
operating
conditions:
no
wastage,
no
inefficiencies, no idle time, no breakdowns
Attainable standards
• a standard which can be attained if production
is carried out efficiently, machines are properly
operated and/or materials are properly used.
Current standards
• standard based on current working conditions
(current wastage, current inefficiencies)
Basic standard
• a long-term standard which remains unchanged
over the years and is used to show trends
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Sources of information for setting standards
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Standard costing
• Management by exception: is defined as the ‘practice of concentrating on activities that require attention
and ignoring those which appear to be conforming to expectation.
• Standard costs are average expected unit costs. So actual results will vary to some extent above or below
the average.
• Standard costs can be viewed as benchmarks for comparison purposes, variances should be reported and
investigated if there is difference between actual and standard.
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Standard costing
Purpose
Setting budgets and evaluating managerial performance
Control device via variance analysis
Predict future cost to be used in decision making
Inventory valuation
Provide challenging targets to motivate staffs and managers
Provide guidance on improvement of efficiency
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Standard costing
Advantages
Disadvantages
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•
•
•
•
Annual detailed examination
Performance appraisal
Management by exception
Simplifies bookkeeping
• Standards not updated cost
• Unrealistic standards can
demotivate staff
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Apply in services environments
Standard costing was originally used in manufacturing environments and a criticism levelled at standard
costing was its apparent lack of applicability in service industries.
The application of standard costing in service industries does have its problems.
• It can be difficult to establish a measurable cost unit for some services.
• In some service organisations every cost unit will be different
• Since the human influence is so great in many services it can be difficult to predict and control the quality of
the output and the resources used in its production.
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
What is a variance?
• A variance is the difference between planned, budgeted, or standard cost and the actual cost
incurred. The same comparison can be made for revenues. (CIMA Official Terminology)
• Variance analysis is the process by which total difference between standard and actual result is
analysed
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Variances
Actual
results
DIFFERENCES
=
VARIANCES
Expected
results
Actual results are better than
expected results Can be
FAVOURABLE
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Variances
Actual
results
DIFFERENCES
=
VARIANCES
Expected
results
Actual results are worse than
expected results
Can be ADVERSE
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Manager’s responsibility
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Variances can be divided into three main groups
Variable cost
variances
Fixed
production
overhead
variances
Variance
• Direct material
• Direct labour
• Variable production overhead
Sales
variances
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Setting standards for material costs
Careful investigation and research:
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Purchase contracts
already agreed
Pricing discussions
with regular suppliers
Quotations and
estimates from
potential suppliers
The forecast
movement of prices in
the market
The availability of
bulk purchase
discounts
Material quality
required
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Material variance
Material total variance measures the difference between the standard material cost of the output produced
and the actual material cost incur.
• Material price variance: difference between standard cost and actual cost for actual quantity of material
used or purchased
• Material usage variance: difference between 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.
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Example ‐ Material variances
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 variance
(a) Material total variance
(b) Material price variance
(c) Material usage variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Example ‐ Material variances – Solution
(a) Material total variance
£
1,000 units should cost (1,000 x £100)
Actual cost
100,000
98,631
Material total variance
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1,369
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(F)
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Example ‐ Material variances – Solution
b) Material price variance
£
11,700 Kgs should cost (11,700 x £10)
117,000
Actual cost
98,631
Material price variance
18,369
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Example ‐ Material variances – Solution
c) Material usage variance
1,000 units should used (x 10 kg)
19,000
Kgs
Actual used
11,700
Kgs
1,700
(A)
Usage variances in kgs
x standard price per kilogram
£10
Material usage variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Standard costing
Material variances formula:
• Material price variance = (Standard price per unit of materials – Actual price per unit of materials) x Actual
quantity of materials = (SP – AP) x AQ
• Material usage variance = (Standard quantity of materials for actual output – Actual quantity used) x Standard
price per unit of material = (SQ – AQ) x SP
• Total material cost variance = Material price variance + Material usage variance = (SP x SQ) - (AP x AQ)
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Material variance
Practice question 1
Cement PLC manufactured 10,000 bags of cement during the month of January. Following raw materials were
purchased and consumed by Cement PLC during the period:
Material
Quantity
Actual Price
Standard
Price
Limestone
100 tons
$75/ton
$70/ton
Clay
150 tons
$20/ton
$24/ton
Sand
250 tons
$10/ton
$12/ton
Required: Calculate the material price variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Material variance
Practice question 2
Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of raw
materials during the period was as follows:
Material
Quantity
Used
Standard
Usage Per Bag
Actual
Price
Standard
Price
Limestone
100 tons
11 KG
$75/ton
$70/ton
Clay
150 tons
14 KG
$21/ton
$20/ton
Sand
250 tons
26 KG
$11/ton
$10/ton
Required: Calculate the material usage variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Material variance
Materials variances and opening and closing inventory
• If closing inventory are valued at standard cost, price
variance is calculated on materials purchases in the
period
• If closing inventory are valued at actual cost, price
variance is calculated on materials used in the period
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Material variance
When to calculate the material price variance
• If variance are extracted at the time of purchase,
they will brought to the attention of manager earlier
then if they are extracted as materials is used.
• Since variances are extracted at the time of
purchase, all inventories will be valued at standard
price
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Labour variance
Labour total variance measures the difference between standard labour cost of the output produced and the
actual labour cost incurred.
Labour total variance can be divided into:
• Labour rate variance: difference between standard cost and actual cost for actual number of hours paid
for.
• Labour efficiency variance: difference between hours that should have been worked for the number of
units actually produced, and actual number of hours works, valued at the standard rate per hour.
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Example ‐ Labour variances
The standard labour rate cost of product X is as follows:
2 hours of grade Z labour at £10 per hour = £20 per unit of product X During the period, 1,000 units of
product X were made, and the labour cost of grade Z labour was £17,825 for 2,300 hours of works.
Requirement: Calculate the following variance
(a) Labour total variance
(b) Labour rate variance
(c) Labour efficiency variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Example ‐ Labour variances – Solution
(a) Labour total variance
£
1,000 units should cost (1,000 x £20)
20,000
Actual cost
17,825
Labour total variance
2,175
(F)
b) Labour rate variance
2,300 hours should cost
23,000
Actual cost
17,825
Labour rate variance
c) Labour efficiency variance
1,000 units should take hours (x 2 hours)
Actual take hour
Efficiency variance
x standard rate per hour
Labour efficiency variance
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5,175
(F)
2,000
Hrs
2,300
Hrs
300
(A)
£10
£3,000
(A)
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Labour variances formula
•
•
Labour rate variance
=
(Standard rate of pay per hour – Actual rate of pay
=
(SR – AR) x AH
per hour) x Actual labour hours
Labour efficiency variance
=
(Standard labours hours for actual output – Actual labour hours) x Standard rate of pay per hour
=
(SH – AH) x SR
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Labour variances
Practice question
DM is a denim brand specializing in the manufacture and sale of hand-stitched jeans trousers.
DM manufactured and sold 10,000 pairs of jeans during a period.
Information relating to the direct labor cost and production time per unit is as follows:
Direct Labor
Actual Hours
Per Unit
Standard
Hours
Per Unit
Actual Rate
Per Hour
Standard
Rate
Per Hour
0.50
0.60
$12
$10
Required: Calculate the labor rate variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Variable production overhead variance
Variable production overhead total variance measures difference between variable production overhead
that should be used for actual output and the variable production overhead actually used.
Variable production overhead total variances can be divided into:
• Variable production overhead expenditure variance measures actual cost of any change from standard
variable overhead rate per hour.
• Variable production overhead efficiency variance is standard variable production overhead cost of any
change from standard level of efficiency.
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Example – VOH variances
The variable overhead cost of product X is as follow:
2 hours at £1.5 = £3 per unit
During the period, 400 units of product X were made.
The labour force worked 760 hours.
The variable overhead cost was £1,672.
Calculate the following variance
(a) Variable overhead total variance
(b) Variable overhead expenditure variance
(c) Variable overhead efficiency variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Example – VOH variances – Solution
(a) Variable overhead total variance
(b) Variable overhead expenditure variance
£
£
400 units should cost (400 x £3)
1,200
Actual cost
1,672
Variable overhead total variance
472
(A)
760 hours of variable should cost
(760 x £1.5)
1,140
Actual cost
1,672
Variable overhead expenditure variance
532
(A)
c) Variable overhead efficiency variance
400 units should take hours (x 2 hours)
800
Hrs
Actual take hour
760
Hrs
40
(F)
Variable overhead expenditure variance
x standard rate per hour
£1.5
Variable overhead efficiency variance
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£60
(F)
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Variable production overhead variance formula
• Variable overhead expenditure variance
=
(Standard variable overhead rate per hour – Actual variable overhead rate per hour) x Actual labour hours
=
(SR – AR) x AH
• Variable overhead efficiency variance
=
(Standard hours for actual output – Actual output) x Standard variable overhead rate per hour
=
(SH – AH) x SR
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Variable production overhead variance
Practice question 1
AAA
Sports
LTD
is
a
small
manufacturing company specializing in
the production of cricket bats. AAA
Sports LTD currently manufactures 2
types of bats:
AAA Plus - a hand-crafted English
Willow bat designed for professional
use
AAA Gold - a machine-manufactured
cheaper bat designed for casual cricket
Number of Hours
Overheads:
Indirect Labor
Polish
Sand paper
Glue
Machine lubricants
Electricity
Total
Following is a break-up of the standard
AAA Plus
2 direct labor hours
AAA Gold
1 machine hour
$10
$5
$1
$1
$3
$20
($10 per direct labor
hour)
$1
$0.5
$0.5
$10
$12
($12 per machine
hour)
variable manufacturing overhead costs:
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Variable production overhead variance
Practice question 1
Following information relates to the actual data from last month:
Variable Manufacturing Overheads
Direct Labor Hours
$175,000
10,000
Machine Hours
5,000
Production (units) - AAA Plus
4,500
Production (units) - AAA Gold
5,200
Required: Calculate the Variable Overhead efficiency Variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Fixed OH variance
• Fixed overhead expenditure variance: The difference between the budgeted
fixed overhead expenditure and actual fixed overhead expenditure.
• The fixed overhead expenditure variance is
(Budgeted fixed overhead cost – Actual fixed overhead cost)
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Sales variances
• The selling price variance is the difference between what revenue should have been for the quantity sold and
the actual revenue
• The sales volume variance is the difference between the actual and budgeted sales volumes, valued at the
standard profit or contribution margin per unit
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Example ‐ Sales variances
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.
Requirement: Calculate the following variance
(a) Sale price variance
(b) Sale volume variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Example ‐ Sales variances ‐ Solution
(a) Sale price variance
b) Sale volume variance
£
Sale revenue from 7,700 units
(7,700 x £12)
92,400
Actual was (7,700 x £12.5)
96,250
Sale price variance
3,850
(F)
Budgeted sales volume
8,000 unit
s
Actual sales volume
7,700 unit
s
Sale volume variance in units
x Standard contribution
Sales volume variance
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300
(A)
£5
1,500
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Sales variance formula
•
•
Sale price variances
=
(Actual selling price per unit –Standard selling price per unit) x Actual sale quantity
=
(AP – SP) x AQ
Sale volume variance
=
(Actual sales quantity – Budgeted sales quantity) x Standard contribution per unit
=
(AQ – BQ) x SC
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Sales variance
Practice question
ABC PLC is a fertilizer producer which specializes in the manufacture of NHK-II (a chemical fertilizer) and ORG-I
(a types of organic fertilizer).
Following information relates to the sale of fertilizers by ABC PLC during the period:
Material
Quantity
Acutal Price
Standard Price
NHK-II
200 tons
$380/ton
$400/ton
ORG-I
300 tons
$660/ton
$600/ton
Required: Calculate the Sales Price Variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Sales variance
Practice question
Wrangler Plc is a manufacturer of jeans
trousers and jackets.
Information relating to Wrangler Plc's
sales during the last period is as follows:
Trousers
Units
Budgeted
12,000
5,000
Actual
10,000
8,000
Standard costs and revenues per unit of
trouser and jacket are as follows:
Wrangler Plc uses marginal costing to
prepare its operating statement.
Required: calculate the Sales Volume
Variance
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Jackets
Units
Trousers
$
Jackets
$
Revenue
20
Direct labor
5
10
Direct Material
6
15
Variable Overheads
4
10
Fixed Overheads
2
5
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Operating statement
An operating
statement
• is a regular report for management
which compares actual costs and
revenues with budgeted figures and
shows variances.
There are several ways in which an operating statement may be
presented. Perhaps the most common format is one which
reconciles budgeted profit to actual profit. Sales variances are
reported first, and the total of the budgeted profit and the two sales
variances results in a figure for 'actual sales minus the standard
cost of sales'. The cost variances are then reported, and an actual
profit calculated.
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Operating statement
Interactive question 1
Work example
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Investigation of variances
• Materiality: Small variations could be not worthwhile for further investigation
• Controllability: Uncontrollable variances call for a change in the standard, not an investigation into the past
• Variance trend: The trend provides an indication of whether the variance is fluctuating within acceptable
control limits or becoming out of control.
• Reliability/variability: a mistake or inaccurate figures could unsurprisingly create variances. Therefore, we
should investigate the mistake rather than variances.
• Cost vs. benefit
• Significance of variance: A variance can be considered significant if it influences management’s actions and
decisions.
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Decision on whether investigate or not
Controllability
The type of
standard being
used
Interdependence
between
variances
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Variance trend
Cost of
investigation
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Variance investigation
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Causes of variances ‐ Material
Variance
Material price
Material usage
Favorable
Adverse
• Unforeseen discount received
• Price increase
• Greater care in purchasing
• Careless purchasing
• Change in material standard
• Change in material standard
• Material used of higher quality than standard
• Defective material
• More efficient use of material
• Excessive waste or theft
• Errors in allocating material to jobs
• Stricter quality control
• Errors in allocating material to
jobs.
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Causes of variances ‐ Labour
Variance
Favourable
Labour rate
Adverse
• Use of workers at a rate of pay lower • Wage rate increase
than standard
Labour
• Output produced more quickly than • Lost time in excess of standard
efficiency
expected
because
of
worker • Output lower than standard set because
motivation, better material, etc
• Errors in allocating time to jobs
of lack of training, sub-standard material,
etc
• Error in allocating time to jobs
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Causes of variances – Variable overhead
Variance
Variable overhead
expenditure
Variable overhead
efficiency
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Favourable
Adverse
• Change in types of overhead or • Change in type of overhead
their cost
or their cost
• As for labour efficiency (if • As for labour efficiency (if
based on labour hours)
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Causes of variances – Sales
Variance
Sales price
Favorable
Adverse
• Supply shortages meant customers • Supply surplus meant customers
prepared to pay higher prices
wished to pay lower price
• Quantity discount given to customers • Quantity
were lower than expected
• Original standard selling price set too
low
discount
given
to
customers were higher than
expected
• Original standard selling price
set too high
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Causes of variances – Sale
Variance
Sales Volume
Favorable
Adverse
• Efficient sales force
• Demotivated sales force
• Successful advertising campaign
• Competitor increased advertising
• Potential market was larger than
expected
effort
• Original budgeted sales were too
• Original budgeted sales were very
optimistic
conservation
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Interdependence of variances
• Variances may affect each other
• e.g. Material price and usage
Cheaper materials
Favorable price variance
Inferior quality
Adverse usage variance (&
efficiency?)
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Interdependence of variances
• Variances may affect each other
• e.g. Labour rate and efficiency
Higher rate paid
Adverse rate variance
Experience & skills
Favorable efficiency variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Interdependence of variances
• Variances may affect each other
• e.g. Sales price and demand/sale volume
Increase in price
Favorable price variance
Fall in demand
Adverse sales volume
variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Interdependence of variances
• Variances may affect each other
• e.g. Cost and sales variances
Fav. Cost variances
Lower quality
Fall in demand
Adverse sales volume
variance
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Deriving actual data from standard cost details and variances
Worked example: Deriving actual data
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
96
Labour 6 hours  £12 per hour
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.
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Deriving actual data from standard cost details and variances
Worked example: Deriving actual data
Requirements
Calculate the following.
(a)
Actual output
(b)
Actual hours worked
(c)
Average actual wage rate per hour
(d)
Actual number of kilograms purchased and used
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Deriving actual data from standard cost details and variances
Worked example: Deriving actual data – Solution
(a)
£
Total wages cost
171,320
Adjust for variances:
Labour rate
(10,598)
Labour efficiency
8,478
Standard wages cost
 Actual output
169,200
= Total standard cost  unit standard cost
= £169,200  £72
= 2,350 units
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Deriving actual data from standard cost details and variances
Worked example: Deriving actual data – Solution
(b)
£
Total wages cost
171,320.0
Less rate variance
(10,598.0)
Standard rate for actual hours
160,722.0
 Standard rate per hour
÷ £12.0
Actual hours worked
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13,393.5 hrs
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Deriving actual data from standard cost details and variances
Worked example: Deriving actual data – Solution
(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 ( £6)
6.0x
but did cost ( £5.50)
5.5x
Material price variance
0.5x

£0.5x
=
£18,840

x
=
37,680 kgs
Alternatively the formula for the material price variance could be used as follows.
Price variance
=
(SP – AP)  AQ
£18,840
=
£(6 – 5.50)  AQ
AQ
=
£18,840 /£0.50
=
37,680 kgs
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CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS
Data bias in variance analysis
 A variance report may highlight a manager’s failure to achieve a budget target without recognising that, say,
the adverse variance against the budget is only half as large this month as it was last month. Comparative
information should be presented as well, if the information is to be interpreted fairly.
 A manager in a large company will compare information about the price of supplies on the open market
with the price that will be charged to her for the supplies if she buys them from another division or
subsidiary of her company. If she finds that the goods produced by the competitor company are cheaper, she
will buy them from outside; but for a variety of reasons this may not be in the best interests of the company
as a whole. The internal price needs to be ‘neutral’ so that it leads the manager to take the decision that is in
the bestinterests of both her own division and of the company as a whole.
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CHAPTER 10
BREAKEVEN ANALYSIS AND
LIMITING FACTOR ANALYSIS
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Content
1. Breakeven analysis and contribution
2. Breakeven charts
3. Limiting factor analysis
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Breakeven analysis and contribution
• Breakeven analysis or cost-volume-profit (CVP) analysis is the study of the interrelationships
between costs, volume and profit at various levels of activity.
• The total contribution from the sales volume for a period can be compared with the fixed costs
for the period. Any excess of contribution is profit, any deficit of contribution is a loss.
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Break‐even analysis
Breakeven point:
The point where total costs =
total sales revenue
&
Where there is neither a profit
or loss
Breakeven point = Number of units of sale required to break even
B/E Point (units) =
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or
B/E Point (units) =
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Break‐even activity
Cost volume profit (CVP) analysis
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Break‐even activity
Cost volume profit (CVP) analysis
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Basic Breakeven chart
Cost volume profit (CVP) analysis
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Break‐even analysis
• Profit = (Contribution per unit x units) – Fixed costs
• Contribution = Sales value – all variable costs
A product has a sales price of £20 and a variable cost of £10 per unit
Units
0
100
500
1,000
1,500
Contribution (£)
0
1,000
5,000
10,000
15,000
Fixed costs (£)
(10,000)
(10,000)
(10,000)
(10,000)
(10,000)
Profit (£)
(10,000)
(9,000)
(5,000)
0
5,000
10
10
10
10
0
(90)
(10)
50
Contribution per unit
Profit per unit
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Contribution to Sales ratio
Contribution to Sales Ratio (C/S ratio)
=
(Contribution per unit) / Unit Sales Price
=
Profit / Volume (P/V Ratio)
Breakeven Point in Sales Value
=
Fixed Costs / C/S ratio
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
The Margin of Safety
The Margin of Safety represents the level by
which output can fall before the organisation
makes a loss
Margin of safety =
x 100%
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
The Margin of Safety
Example:
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.
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
The Margin of Safety
Example – 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) x 100% = 12½% of budget
(c) 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.
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CVP analysis and profit target
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 decision
• Breakeven with required profit
Sales for a certain level of profit
Fixed costs
required profit
Contribution per unit
• Breakeven with change in selling price to maintain current profit
• Breakeven with change in production cost to maintain current profit
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Break‐even analysis
Variations on breakeven and profit target calculations
You may come across variations on breakeven and profit target calculations in which you will be expected to
consider the effect of altering the selling price, variable cost per unit or fixed cost.
Worked example:
Stomer Cakes Ltd bake and sell a single type of cake. The variable cost of production is £0.15 per cake and the
current sales price is £0.25 per cake. Fixed costs are £2,600 per month, and the annual profit for the company at
the current sales volume is £36,000. The volume of sales demand is constant throughout the year.
The sales manager wishes to raise the sales price to £0.29 per cake, but considers that a price rise will result in
some loss of sales.
Requirement: Ascertain the volume of sales required each month to maintain current profitability, if the
selling price is raised to £0.29.
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Break‐even analysis
Worked example: Change in production costs
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.
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Break‐even chart
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.
A breakeven chart has the following axes.
•
A horizontal axis showing the sales/output (in value or units)
•
A vertical axis showing £ for sales revenues and costs
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Break‐even chart
Worked example: A breakeven chart
The budgeted annual output of a factory is 120,000 units. The fixed overheads amount to £40,000 and the
variable costs are 50p per unit. The sales price is £1 per unit.
Requirement
Construct a breakeven chart showing the current breakeven point and profit earned up to the present
maximum capacity of 120,000 units.
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Break‐even chart
Worked example: A breakeven chart – Solution
We begin the construction of the breakeven chart by calculating the profit at the budgeted annual output.
£
120,000
60,000
60,000
40,000
20,000
Sales (120,000 units)
Variable costs
Contribution
Fixed costs
Profit
The breakeven chart is shown on the following page.
The chart is drawn as follows.
(a) The vertical axis represents money (costs and revenue) and the horizontal axis represents the level of
activity (production and sales).
(b) The fixed costs are represented by a straight line parallel to the horizontal axis (in our example, at
£40,000).
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Break‐even chart
Worked example: A breakeven chart – Solution
(c) The variable costs are added ‘on top of’ fixed costs, to give total costs. It is assumed that fixed costs are the
same in total and variable costs are the same per unit at all levels of output.
The line of costs is therefore a straight line and only two points need to be plotted and joined up. Perhaps the
two most convenient points to plot are total costs at zero output, and total costs at the budgeted output and
sales.
•
At zero output, costs are equal to the amount of fixed costs only, £40,000, since there are no variable
costs.
•
At the budgeted output of 120,000 units, total costs are £100,000.
£
40,000
60,000
100,000
Fixed costs
Variable costs 120,000 × 50p
Total costs
(d) The sales line is also drawn by plotting two points and joining them up.
•
At zero sales, revenue is nil.
•
At the budgeted output and sales of 120,000 units, revenue is £120,000
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Break‐even chart
£’000
Sa
le
s
120
Budgeted profit
100
Breakeven point
80
Budgeted variable costs
sts
l co
a
t
To
60
Fixed costs
40
Margin
of safety
20
Budgeted fixed costs
0
0
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20
40
60
80
100
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120
‘000 Units
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Contribution Breakeven chart
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Limitations/Assumptions of CVP
Can only apply to a single product or constant mix of a group of products
Time consuming to prepare breakeven chart
Costs behaviour is assumed to be linear
Revenue is assumed to be linear
Volume Produced = Volume Sold
Ignores inflation and uncertainty in the estimates of sales prices, fixed costs and variable cost per unit
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Limiting Factors Analysis
• A limiting factor (or key factor) is any factor that is in scarce supply and that stops the
organization from expanding its activities further, that is, it limits the organization’s
activtities
• Labour
• Materials
• Manufacturing capacity
• In limiting factor analysis, management wishes to maximize profit and that since there is
no change in the fixed cost incurred, profit will be maximized when contribution is
maximized.
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Decisions with One Limiting Factor
Limiting factor needs
to be identified.
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It is the scarce
resource that limits
production below
maximum demand.
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Decision is to rank
products that
maximize
contribution per
limiting factor.
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Limiting Factors Analysis
• Contribution will be maximized by earning the biggest possible contribution
per unit of limiting factor.
• Where there is just one limiting factor, the technique for establishing the
contribution maximizing product or service mix is to rank the products or
services in order of contribution-earning ability per unit of limiting factor.
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Limiting Factors Analysis
1.Calculate contribution per unit.
Calculate contribution per unit of the limiting factor.
Rank in order.
Allocate resources - make first up to max demand, then
second,...
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Activity: Limiting Factor Analysis
Material J is restricted to 12,000 kg.
Product
Contribution per unit ($)
Kg of J per unit
A
16
4
B
10
2
C
24
8
Required:
Calculate the maximum contribution which can be achieved.
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Activity: Limiting Factor Analysis – Answer
Product
Contribution per unit
Kg per unit
Contribution per kg
Rank
A
B
C
$16
4
$4
2
$10
2
$5
1
$24
8
$3
3
Therefore produce 12,000/2 = 6,000 units of B
Maximum contribution = 6,000 × 10 = $60,000
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Limiting Factors Analysis
Interactive question 5
Work example
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Restricted freedom of action
Products that can be produced and sold is also restricted by a factor other than a scarce resource
• 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
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Limiting Factors Analysis
Worked example: Limiting factor
AB Ltd makes two products, the Ay and the Be. Unit variable costs are as follows.
Ay
£
Materials
1
Labour (£9 per hour)
18
Overhead
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. 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.
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Limiting Factors Analysis
Solution
Step 1 ‐ Confirm that the limiting factor is something other than sales demand.
Ays
2 hrs
3,000 units
6,000 hrs
Labour hours per unit
Sales demand
Labour hours needed
Labour hours available
Shortfall
Bes
1 hr
5,000 units
5,000 hrs
Total
11,000 hrs
8,000 hrs
3,000 hrs
Labour is the limiting factor on production
Step 2 ‐ Identify the contribution earned by each product per unit of limiting factor, that is per labour hour
Ays
Bes
worked.
£
£
Sales price
26
17
Variable cost
20
13
Unit contribution
6
4
Labour hours per unit
Contribution per labour hour (= unit of limiting factor)
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2 hrs
£3
1 hr
£4
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Limiting Factors Analysis
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
11,000
Hours
needed
5,000
3,000
8,000
Less fixed costs
Profit
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Hours
available
5,000
3,000 (bal)
8,000
Contribution
per hour
£
4
3
Priority of
manufacture
1st
2nd
Total
£
20,000
9,000
29,000
20,000
9,000
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Restricted freedom of action
Worked example
Restricted freedom of action
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Make vs. buy decision
• Decision: whether an organization should make a product or it should pay to
another organization to do so.
• Relevant costs are the differential costs between two options
• Practical?
• Manufacture own components?
• Do some work with own employees?
• Carry out services by own department?
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Make vs. buy decision
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.
Buying help from outside is justifiable if it adds to profits. A further decision is then required on how to
split the work between internal and external effort. What 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 saved by buying.
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Make vs. buy decision
Worked example
Make or buy decisions with scarce
resources
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Practice question
Shellfish Co makes four components, W, X, Y and Z, for which costs in the forthcoming year are expected to be as
follows.
Directly attributable fixed costs per annum and committed fixed costs:
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CHAPTER 10: BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS
Practice question
Directly attributable fixed costs are all items of cash expenditure that are incurred as a direct
consequence of making the product in-house.
A subcontractor has offered to supply units of W, X, Y and Z for $12, $21, $10 and $14 respectively.
Required: Should Shellfish make or buy the components?
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CHAPTER 11
INVESTMENT APPRAISAL
TECHNIQUES
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Content
Making investment appraisal decisions
The payback method
The accounting rate of return method
The net present value method
The internal rate of return method
Environmental costing
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Methods of CAPEX appraisal
Payback
Accounting
rate of
return
IRR method
of DCF
Discounted
payback
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NPV method
of DCF
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Payback method of appraisal
• Payback is the amount of time it is expected to
take for the cash inflows from a capital
investment project to equal the cash outflows
• Use as initial screening method then evaluate
using another investment appraisal method.
• The usual decision is to accept the project with
the shortest payback period
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Payback method of appraisal
Even annual cash flow:
𝐏𝐚𝐲𝐛𝐚𝐜𝐤 𝐩𝐞𝐫𝐢𝐨𝐝
𝐂𝐚𝐬𝐡 𝐨𝐮𝐭𝐥𝐚𝐲 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
𝐀𝐧𝐧𝐮𝐚𝐥 𝐜𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰
Example:
Investment in project A: $100,000. Annual inflow cash flow from project A:$40,000.
Required: Calculate payback period?
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Payback method of appraisal
Uneven annual cash flows
•
Payback is calculated by finding out when the cumulative cash inflows from
the project will pay back the money spent.
Payback alone is an inadequate appraisal techniques
Worked example
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Payback method of appraisal
Worked example: Payback period
An asset costing £120,000 is to be depreciated over 10 years to a nil residual value. Profits after depreciation for
the first five years are as follows.
Year
£
1
12,000
2
17,000
3
28,000
4
37,000
5
8,000
Requirement
Calculate the payback period to the nearest month.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Payback method of appraisal
Advantages
Disadvantages
Easy to calculate
not consider post-payback cash flows
Put more emphasis to quick return of the invested fund
not consider time value of money
Easy to apply
"acceptable" time period is arbitrary
Unable to distinguish between projects
The choice of any cut-off payback period is arbitrary
Not take in to account variability of CF
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Accounting Rate of Return (ARR)
The Accounting Rate of Return (ARR) method of appraising a project involves estimating the accounting rate
of return that a project should yield.
If it exceeds a target rate of return then the project is acceptable
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ARR
Avg. annual accounting profit
Initial investment
ARR
Avg. annual accounting profit
Avg. investment
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x 100%
x 100%
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Accounting Rate of Return (ARR)
Initial investment = cost of investment at beginning
Average investment = (initial investment + final/scrap value)/2
Average profit = (profit before depreciation – depreciation)/years
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Accounting Rate of Return (ARR)
Worked example: The accounting rate of return
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.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Accounting Rate of Return (ARR)
Worked example: The accounting rate of return – Solution
(a) Using initial investment
(b) Using average investment
Average profit
£ ,
= (profit before depreciation – depreciation)/years
£
,
,
/
x 100% = 6.7%
= [(£24,000 x 5) – (£110,000 - £10,000)]/5
= £4,000 p.a
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Accounting Rate of Return (ARR)
Mutually exclusive project
Two projects are mutually exclusive when the only one
project can be selected and implemented.
For example: Acquisition of new machine or Hiring new
machine.
The ARR can be used to select. The project with highest ARR
would be selected.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Accounting Rate of Return (ARR)
Interactive question 1: The ARR and mutually exclusive projects
Arrow wants to buy a new item of equipment. Two models of equipment are available, one with a slightly higher
capacity and greater reliability than the other. The expected costs and profits of each item are as follows.
Capital cost
Life
Profits before depreciation
Year 1
Year 2
Year 3
Year 4
Year 5
Disposal value for equipment
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Equipment
item
X
£100,000
5 years
£
50,000
50,000
30,000
20,000
10,000
20,000
Equipment
item
Y
£175,000
5 years
£
50,000
50,000
60,000
60,000
60,000
25,000
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Accounting Rate of Return (ARR)
Interactive question 1: The ARR and mutually exclusive projects
Arrow wants to buy a new item of equipment. Two models of equipment are available, one with a
slightly higher capacity and greater reliability than the other. The expected costs and profits of each
item are as follows.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Accounting Rate of Return (ARR)
Advantages
Disadvantages
Simple
Does not take into account time value
of money
Familiar concept of percentage return
Based on accounting profit rather than
cash flow, subject to accounting
policies
Easily calculated from financial
statements
Looks at the entire project life
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The relative measure does not take
into account the size of the project
does not take into account the length
of the project
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Discounted Cash Flow ( DCF ) Techniques
" Time value of money " : investors prefer to receive a $ 1 today rather than $ 1 in one year.
Key point
Discounted cash flow techniques take account of the time value of money by restating
each future cash flow in terms of its equivalent value today.
Advantages:
• Time value of money is accounted for
• All of project's cash flows are considered
• The timing of cash flows is allowed for
Limitations :
• Potentially complex and time consuming
• Difficult to explain to non - financial managers
• Difficulty in estimating an appropriate discount rate
• Managers may feel little connection between DCF techniques and their own reported performance
and bonus systems
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Net Present Value (NPV)
Project may take for a number of year, we call they are
long term decision.
One of thing company will need to consider when
investing in long term projects is the time value of
money.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
Time value of money
Future
value
Present value
0
1
2
3
Years
Option A $10,000
$10,000 + interest
Option B $10,000 - interest
$10,000
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
Interest
Interest is the amount of money which an investment earns overtime
Simple interest
I = prt
Time (in years)
Interest
Principal
Annual interest rate
Interest for year I is not added to principal for
calculation of interest for year 2
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
Compound Interest and terminal value
𝐕
𝐗 𝟏
𝐫
𝐧
Eg: Invest 100$ in 3 years
Where:
• V: Future or terminal value
• X: Present or initial value
• r: Compound rate of return
• n: Number of time periods
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Interest earn is added to principal before
computing interest for the next year
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
Example
Find the present value of:
1.
$250 received or paid in 5 years' time, r = 6% per year.
2.
$30,000 received or paid in 15 years' time, r = 9% per year.
Use the present value table
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
Terminal value ‐ example
What is the terminal value of £200 invested today at an interest rate of 7% per annum in
10 years’ time?
Solution
Terminal value = £200 × (1.07) 10 = £393
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
Discounting and discount factor
Discounting is converting future value to present value
• Discounting formula:
X = V / (1+r)n
Discount factor: A present value for a future cash flow is calculated by multiplying
the future cash flow by a discount factor
• Discount factor formula:
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1 / (1+r)n
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
Interactive question 2: Present value calculation
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%.
Calculate the present value of these future returns.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
Nominal vs effective interest rates
Interest may be paid or charged on a daily, weekly, monthly, quarterly, half-yearly or yearly basis.
The annual interest rate quoted before compounding is called the nominal rate of interest
𝐞
𝟏
𝐢 𝐧
‐1
𝐧
i = stated annual interest rate
n = number of compounding periods
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
Accounting profit vs cash flows
• Accounting profits, prepared on an accrual basis, do not properly reflect investment return.
• Capital investment appraisals should be based on cash flow, as these are relevant costs for decision making.
• The only cash flows that should be taken into consideration in capital investment appraisal are:
o Cash flows that will happen in the future; and
o Cash flows that will arise only if the capital project goes ahead.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
NPV ‐ Procedure
• Forecast the relevant cash flows from the project.
1
• Estimate the required return of investors (i.e. the discount rate). For a project that has risk equal to the
company's risk, the required return of investors represents the company's overall cost of finance (also
referred to as its cost of capital).
2
• Discount each cash flow (receipt or payment) to its present value (PV).
3
• Sum present values to give the NPV of the project.
4
• If NPV is positive then accept the project as it provides a higher return than required by investors (i.e.
the company’s cost of capital).
5
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
𝐍𝐏𝐕
𝐂𝟏
𝐂𝟎
𝐂𝐓
Where:
𝐶
•
𝟏
= Initial investment
•
C
= Cash flow
•
r
= Discount rate
•
T
= Time
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𝟏
𝐫
𝐓
𝐂𝟐
𝐫
𝟏
𝐫
𝟐
……
• NPV > 0  Accept on financial basis
• NPV< 0  Rejected on a financial basis
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
Net present value
Worked example NPV
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
• Assumptions in DCF about the timing of cash flows
o
Cash outlay at beginning of an investment project (now) occur in Year 0;
o
Cash flow that occurs during the course of a year is assumed to occur all at once at the end of the year;
o
If a cash flow occurs at the beginning of a year, it is assumed that the cash flow happens at the end of
the previous year.
• Remember that if depreciation has been deducted from a profit figure, it must be added back to give the net
cash flow
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Annuities
Annuities An annuity is a constant
annual cash flow over a number of
years.
Worked example
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Annuities
Worked example: The net terminal value
A project has the following cash flows.
Year
£
0
(5,000)
1
3,000
2
2,600
3
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.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Annuities
Net terminal value
Example: 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.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Annuities
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Advantages of NPV
It is directly linked to the assumed objective of maximising shareholder wealth as it measures, in absolute (£)
terms, the effect of taking on the project now, i.e. year 0.
•
It considers the time value of money, i.e. the further away the cash flow the less it is worth in present
terms.
•
It considers all relevant cash flows, so that it is unaffected by the accounting policies which cloud profitbased investment appraisal techniques such as ARR.
•
Risk can be incorporated into decision making by adjusting the company’s discount rate.
•
It provides clear, unambiguous decisions, ie if the NPV is positive, accept; if it is negative, reject.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Time value of money
DCF 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
• An individual attaches more weight to current pleasures than to future ones, and would rather have £1 to
spend now than £1 in a year’s time.
• Discounted cash flow techniques can therefore be used to measure either of two things.
- What alternative uses of the money would earn (NPV method)
- What the money is expected to earn (IRR method – to be covered in the next section of this chapter)
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Advantage of DCF method
•The method uses all cash flows relating to the project
It allows for the timing of the cash flows
There are universally accepted methods of calculating the NPV and IRR
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Comparison ROI and NPV method
• NPV measures the cash flow of an investment; ROI measures the efficiency of an investment.
• NPV calculates future cash flow; ROI simply calculates the return that the investment produces.
• NPV cannot determine the dedicated investment; ROI can be easily manipulated to the point of inaccuracy.
• If mgt take a short term view, investment would be rejected if the ROI measure were to be used, despite the
fact that investment’s NPV is positive
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Comparison ROI and NPV method
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Discounted payback method
• The payback period is the time when the project NPV reaches 0. A project can only be acceptable applying a
discounted payback rule if it has a NPV of 0 or higher.
•
Discounted Cash Inflow = Actual
Cash Inflow / (1 + i)n
Where
•
i is the discount rate;
•
n is the period to which the cash inflow relates.
Usually the above formula is split into two components which are actual cash inflow and present value factor
(i.e. 1/(1 + i)^n ). Thus discounted cash flow is the product of actual cash flow and present value factor.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Discounted payback method
Practice question
An initial investment of $2,324,000 is
expected to generate $600,000 per year for 6
years.
Required:
Calculate
the
discounted
payback period of the investment if the
discount rate is 11%.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Discounted payback method
Practice question – Solution
Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by
present value factor. Create a cumulative discounted cash flow column.
Year
n
Cash Flow
CF
Present Value
Factor
n
PV$1=1/(1+i)
Discounted Cash
Flow
CF×PV$1
Cumulative
Discounted
Cash Flow
0
$ −2,324,000
1.0000
$ −2,324,000
$ −2,324,000
1
600,000
0.9009
540,541
− 1,783,459
2
600,000
0.8116
486,973
− 1,296,486
3
600,000
0.7312
438,715
− 857,771
4
600,000
0.6587
395,239
− 462,533
5
600,000
0.5935
356,071
− 106,462
6
600,000
0.5346
320,785
214,323
Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32 years
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Discounted payback method
Advantages
•Discounted payback
period is more reliable
than simple payback
period since it accounts for
time value of money. It is
interesting to note that if a
project has negative net
present value it won't pay
back the initial investment.
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Disadvantages
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It ignores the cash inflows
from project after the
payback period.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
The net present value method
Discount rates
Organization may use different discount rates at
different points over the life of a project.
Possible of NPV and discounted payback methods of
appraisal are being used but IRR and ARR methods
are based on a single rate.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Other aspects of discounting
Delayed annuities
A company may take out a loan, agreeing to repay it in equal annual instalments (ie an annuity) but starting
at the end of year 2, so that the first cash flow does not occur until after year 1. As annuity factor tables work
on the assumption that the first cash flow occurs at the end of year 1, care will be needed when using the
tables. Remember that if an annuity factor from the table is used, the present value of the annuity stream is
being found one period before the first annuity flow, so further discounting will be needed to find the
present value at year 0.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Other aspects of discounting
Annual cash flows in perpetuity
Perpetuity is an equal annual cash flow forever
Present Value (PV) of Perpetuity =
A
r
• A is annum amount; R is annual discount rate
Example 1: Calculate the present value on Jan 1, 20X0 of a perpetuity paying $1,000 at the end of each month
starting from January 20X0. The monthly discount rate is 0.8%.
Solution
Periodic Payment A = $1,000 Discount Rate i = 0.8% Present Value PV = $1,000 ÷ 0.8% = $125,000
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Annuities and perpetuities
Perpetuities
Question
(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
Present value one year before the first cash flow = at end of year 3
= £3,000/0.10 = £30,000
(b)
Present value at year 0 = £3,000 × year 3 10% discount factor
= £30,000 × 0.751 = £22,530
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Other aspects of discounting
Changing discount rates
Discount rates can be changed during the project life
Year 0
NPV =
Outflow
Year 1
Inflow/(1+ r1)
Year 2
Inflow/[(1+r1)(1+r2)]
r1 = interest rate for year 1
r2 = interest rate for year 2
Worked example: Changing discount rates
A project’s estimated cash flows are as follows.
Requirement
Calculate the NPV if the cost of capital is 10% for the first year and 20% for the second year.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Worked example: Annuities in advance and delayed annuities
What is the present value of £1,000 received annually for five years if the first receipt is:
(a) in one year's time?
(b) now?
(c) in three years' time? Use a discount rate of 15%.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
• IRR method is an alternative to the NPV method
• IRR method calculates the exact DCF rate of return that the project is expected to achieved.
• Steps in calculating IRR
Calculate two NPV for the project at two different discount rates, one
rate has positive NPV, the other has negative NPV
Estimate the cost of capital at which the NPV is 0 (IRR)
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
Interpolation method
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
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
If we determine a cost of capital where the NPV is (slightly) positive, and another cost of capital where it is
(slightly) negative, we can estimate the IRR – where the NPV is zero – by drawing a straight line between the two
points on the graph that we have calculated.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
•
If we establish the NPVs at the two points P, we would estimate the IRR to be at point A.
•
If we establish the NPVs at the two points Q, we would estimate the IRR to be at point B.
•
The closer our NPVs are to zero, the closer our estimate will be to the true IRR.
•
The interpolation method assumes that the NPV rises in linear fashion between the two NPVs close to zero.
𝐈𝐑𝐑
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𝐀%
𝐍𝐏𝐕 𝐚
𝐱 𝐛
𝐍𝐏𝐕 𝐚
𝐍𝐏𝐕 𝐛
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
Practice question
A is considering investing $250,000 in a business.
The cost of capital for the investment is 13%.
Following cash flows are expected from the investment
Year
$
0
(250,000)
1
50,000
2
100,000
3
200,000
Required: Calculate the IRR for the proposed investment and interpret your answer.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
Practice question – Solution
Step 1: Select 2 discount rates for the calculation of NPVs
We can take 10% (R1) and 20% (R2) as our discount rates.
Step 2: Calculate NPVs of the investment using the 2 discount rates
Net Present Value @ 10%
Cash Flow
A
Discount Factor
B
Present Value
AxB
(250,000)
1.000
(250,000)
50,000
0.909
45,450
100,000
0.826
82,600
200,000
0.751
150,200
NPV1
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28,250
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
Practice question – Solution
Cash Flow
A
Net Present Value @ 20%
Discount Factor
B
Present Value
AxB
(250,000)
1.000
(250,000)
Step 3: Calculate the IRR
50,000
0.833
41,650
Internal Rate of Return
100,000
0.694
69,400
200,000
0.579
115,800
= R1%
+
= 10%
+
= 10%
+
= 10% +
= 15.5%
NPV1 x (R2 - R1)%
(NPV1 - NPV2)
NPV2
‐23,150
28,250 x (20 - 10)%
(28,250 - (- 23,150))
28,250 x 10%
28,250 + 23,150
5.5%
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
Practice question – Solution
Note: A more accurate IRR can be calculated using the
Microsoft Excel's IRR function. Simply write the cash flows
of the investment in separate cells and define the range of
those cells in the IRR function
As you can see, the IRR function returns a value of 15.1%
which varies slightly from the manual calculation above.
Step 4: Interpretation
The investment should be accepted by Mr. A because the cost of capital (i.e. 13%) is lower than the IRR of 15.5%.
The cost of capital will need to increase by more than 19.2%* for the investment to become financially unviable
*15.5% - 13%
13%
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19.2%
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
Graphical approach
The easiest way to estimate the IRR of a project is to find the project’s NPV at a number of costs of capital and
sketch a graph of NPV against discount rate. The graph can be used to estimate the discount rate at which the
NPV is equal to zero (the point where the curve cuts the axis)
Worked example: The IRR method and interpolation
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.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
Graphical approach
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).
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. As a rough guide , try starting at a return figure which is about two thirds or three quarters of the
ARR .
Annual depreciation would be £(80,000 – 10,000)/5 = £14,000.
The ARR would be (£20,000 – depreciation of £14,000)/(½ of £(80,000 + 10,000)) = £6,000/£45,000 = 13.3%.
Two thirds of this is 8.9% and so we can start by trying 9%. The discounted tables do not provide discount
factors for an interest rate of 9% therefore we need to calculate our own factors.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
Advantages
Take into account time value of money
Express as simple percentage
Disadvantages
Can have negative or multiple IRRs
Conflicting with other appraisal methods
Cannot accommodate changing interest rates
IRR may be too high
Ignore the relative size of investments
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
Non‐conventional cashflow
Year
Project X
$’000
0
(1,900)
1
4,590
2
(2,735)
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Analysis examples
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
Mutually exclusive project
Two projects are mutually exclusive when the only
one project can be selected and implemented. For
example: Acquisition of new machine or Hiring new
machine.
IRR method is applied with higher IRR project
would be selected.
Example: page 417
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Internal Rate of Return (IRR)
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 assumes these cash flows can be
reinvested elsewhere to earn a return equal to the IRR of
the original project.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Using NPV, IRR and Payback
Pay back
NPV
IRR
DBP
• Simple payback
• Ignore
discounting
• NCF from an
investment
must pay back
the original
capital outlay
within a given
period of time
• Discount cash
flows relating to
the investment
at the
organization’s
cost of capital
• NPV = ΣPV over
its expected life
• Project is viable
if NPV > 0
• IRR is the
discount rate at
which the NPV
is zero;
• Investment is
financially
viable if IRR >
Ke
• Relating to the
investment at
the
organization’s
cost of capital
• The length of
time before the
cumulative NPV
reaches 0
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Environmental costing
Importance of environmental costs
There are, of course, ethical reasons why environmental costs are important to the management accountant.
For example, using energy generates carbon dioxide emissions, and these contribute to climate change and
threaten the future of our planet. Management accountants, however, should also consider environmental
costs for the following reasons.
• Identifying environmental costs associated with individual products, services or processes helps
with correct product or service pricing. Correct pricing helps to increase profitability.
• Poor environmental behaviour can result in fines, increased liability to environmental taxes and damage to
the business’ reputation.
• Recording environmental costs is important, as some may require regulatory compliance. Most Western
countries now have laws to cover land-use planning, smoke emissions, water pollution and destruction of
animals and natural habitats.
• Saving energy generally leads to cost savings.
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CHAPTER 11: INVESTMENT APPRAISAL TECHNIQUES
Environmental costing
Environmental cost classification
(a) Environmental prevention costs are the costs required to eliminate environmental impacts before they
occur.
For example, forming environmental policies, performing site and feasibility studies, staff training.
(b) Environmental appraisal costs are the costs involved with establishing whether activities are complying
with environmental standards and policies.
For example, developing performance measures, monitoring, testing and inspection costs, site survey costs.
(c) Environmental internal failure costs are the costs of activities that must be undertaken when contaminants
and waste have been created by a business but not released into the environment.
Examples include maintaining pollution equipment and recycling scrap.
(d) Environmental external failure costs are the costs that arise when a business releases harmful waste into
the environment. A business can harm its reputation by doing this.
Examples include cleaning up oil spills or decontaminating land.
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