MA2 - Pocket Notes - 2020/2021
Managing Costs and Finance
Big Thanks to KAPLAN
Promoter - www.ACCAGlobalBox.com
Bo
x
Downloaded From "http://www.ACCAGlobalBox.com"
G
lo
ba
l
Exam MA2
Managing Costs and Finance
AC
C
A
Pocket Notes
www.ACCAGlobalBox.com
Managing Costs and Finance (MA2)
A catalogue record for this book is available
from the British Library.
AC
C
A
Published by:
Kaplan Publishing UK
Unit 2 The Business Centre
Molly Millars Lane
Wokingham
Berkshire
RG41 2QZ
ISBN 978-1-78740-633-9
© Kaplan Financial Limited, 2020
Printed and bound in Great Britain.
P.2
Bo
x
G
lo
ba
l
British library
cataloguing-in-publication
data
The text in this material and any others
made available by any Kaplan Group
company does not amount to advice on a
particular matter and should not be taken
as such. No reliance should be placed on
the content as the basis for any investment
or other decision or in connection with any
advice given to third parties. Please consult
your appropriate professional adviser as
necessary. Kaplan Publishing Limited and
all other Kaplan group companies expressly
disclaim all liability to any person in respect
of any losses or other claims, whether
direct, indirect, incidental, consequential or
otherwise arising in relation to the use of
such materials.
All rights reserved. No part of this publication
may be reproduced, stored in a retrieval
system, or transmitted, in any form or
by any means, electronic, mechanical,
photocopying, recording or otherwise,
without the prior written permission of
Kaplan Publishing.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Managing Costs and Finance (MA2)
Contents
Management information ........................................................................................... 1
Chapter 2
Maintaining an appropriate cost accounting system .................................................. 9
Chapter 3
Cost classification and cost behaviour ...................................................................... 15
Bo
x
Chapter 1
Chapter 4
Costing of materials .................................................................................................. 23
Chapter 5
Materials inventory control ........................................................................................ 29
Labour costs ............................................................................................................ 39
Other expenses ........................................................................................................ 47
Chapter 8
Absorption costing .................................................................................................... 51
G
lo
ba
l
Chapter 6
Chapter 7
Marginal costing and absorption costing ................................................................... 61
Chapter 10
Job costing and batch costing .................................................................................. 65
Chapter 11
Process costing ........................................................................................................ 69
Chapter 12
Service costing ......................................................................................................... 79
Chapter 13
CVP analysis ............................................................................................................ 83
Chapter 14
Decision making ...................................................................................................... 89
Chapter 15
Discounted cash flow and capital expenditure appraisal .......................................... 97
Chapter 16
The nature of cash and cash flows ......................................................................... 109
Chapter 17
Cash management, investing and finance .............................................................. 117
KAPLAN PUBLISHING
AC
C
A
Chapter 9
www.ACCAGlobalBox.com
P.3
Managing Costs and Finance (MA2)
Cash budgets ......................................................................................................... 131
Chapter 19
Information for comparison .................................................................................... 137
Chapter 20
Reporting management information ....................................................................... 149
Index
................................................................................................................................... I.1
AC
C
A
G
lo
ba
l
Bo
x
Chapter 18
P.4
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Managing Costs and Finance (MA2)
These Pocket Notes contain everything you
need to know for the exam, presented in a
unique visual way that makes revision easy
and effective.
Our Quality Co-ordinator will work with our
technical team to verify the error and take
action to ensure it is corrected in future
editions.
AC
C
A
G
lo
ba
l
Written by experienced lecturers and authors,
these Pocket Notes break down content
into manageable chunks to maximise your
concentration.
Quality and accuracy are of the utmost
importance to us so if you spot an error in
any of our products, please send an email
to mykaplanreporting@kaplan.com with full
details, or follow the link to the feedback
form in MyKaplan.
Bo
x
Preface
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
P.5
AC
C
A
G
lo
ba
l
Bo
x
Managing Costs and Finance (MA2)
P.6
www.ACCAGlobalBox.com
KAPLAN
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
1
G
lo
ba
l
Management information
In this chapter
Purpose of management information.
•
Data and information.
•
Qualities of useful management information.
•
Sources of data for management accounting.
•
Cost centres, profit centres and investment centres.
•
IT and management accounting.
AC
C
A
•
www.ACCAGlobalBox.com
1
Management information
Purpose of management
information
Identify objectives
AC
C
A
Search for alternative
courses of action
Gather data about alternatives
G
lo
ba
l
Control is about monitoring what is actually
happening, and if anything seems to be
going wrong, deciding what should be done
to correct the problem.
Plannin
Bo
x
Planning is about making decisions about
what should be done.
Select course of action
Implement plan in the
form of a bud et
Monitor actual results
Control
Respond to diver ences
from plan
The budget cycle
2
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 1
Data and information
Bo
x
Purchase Invoice
Purchase Invoice
G
lo
ba
l
Purchase Invoice
Total purchases = $50,000
Purchase Invoice
Definition
AC
C
A
Purchase Invoice
Data is a collection of unprocessed facts or
opinions.
Definition
Information is data that has been processed
so that it has a purpose and meaning.
Managers need information not data. The cost accountant processes data about income and
expenditures into meaningful figures about the costs of products, services and processes.
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
3
Management information
Qualities of useful
management information
Purposeful
•
Relevant
•
Timely
•
Accurate
•
Complete
•
Communicated properly
•
Cost effective
AC
C
A
G
lo
ba
l
Bo
x
•
4
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 1
Sources of data for management accounting
Data for preparing management information comes from a variety of sources, both within the
organisation (internal sources) and from outside the organisation (external sources).
Internal
sources
Sales and
marketing
records
Customer profiles
Market research
Demand patterns
Newspapers and trade journals
Developments in technolo y
Information on competitors
Share prices
Bo
x
Suppliers
Product prices
Specifications
External
sources
Customers
Product requirements
Price sensitivity
overnment
Industry statistics
Taxation policy
Inflation rates
AC
C
A
Personnel
Wa e demands
Workin conditions
Production records
Performance of machinery
Output
Quality
G
lo
ba
l
Accounting system
Non-current assets
Purchases
Sales
Payroll
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
5
Management information
Cost centres, profit centres
and investment centres
Investment centre
A profit centre with additional
responsibilities for capital
investment and possibly for
financin
G
lo
ba
l
A responsibility centre is an individual part
of a business whose manager has personal
responsibility for its performance.
Bo
x
Hi hest
responsibility
Definition
AC
C
A
Responsibility centres can be defined and
appraised in several different ways:
Lowest
responsibility
Profit centre
A part of the business for
which both the costs incurred
and the revenues earned are
identified
Revenue centre
A part of the or anisation
that earns sales revenue
Cost centre
A part of the or anisation that
incurs costs
Responsibility centres
6
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 1
The manager in charge of a profit centre
is judged on the ability to meet or exceed
profit targets and so must be authorised to
manage both costs and revenues.
AC
C
A
ROCE =
Profit
IT has brought many advantages for
providing management information:
•
information can be gathered more easily
and cheaply,
•
much more information can be gathered
and stored,
G
lo
ba
l
The manager in charge of an investment
centre also has the responsibility for
investment. He or she is judged on return
on capital employed (ROCE).
IT and management
accounting
Bo
x
A manager in charge of a cost or revenue
centre would be evaluated on his or her
ability to meet cost or revenue targets.
Capital employed
In addition to ROCE, an investment centre
manager may be judged on net profit margin
and asset turnover.
•
information can be transmitted quickly
via the internet,
•
computers can process and interpret
data more quickly, and
•
there is a wide range of software which
can simplify the entire process.
ROCE =
Net profit margin × Asset turnover
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
7
AC
C
A
G
lo
ba
l
Bo
x
Management information
8
www.ACCAGlobalBox.com
KAPLAN
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
2
G
lo
ba
l
Maintaining an appropriate
cost accounting system
In this chapter
A cost accounting system.
•
Documentation for the source data.
•
Cost units.
•
Recording and coding of costs.
AC
C
A
•
www.ACCAGlobalBox.com
9
Maintaining an appropriate cost accounting system
A cost accounting system
Cost accounting systems make a distinction
between direct costs and indirect costs.
The cost accounting system can interact with
the financial accounting system:
G
lo
ba
l
Interlocking accounts are a system
in which the cost accounts are distinct
from the financial accounts, the two sets
of accounts being kept continuously
in agreement by the use of control
accounts or reconciled by other means.
AC
C
A
•
Integrated accounts are a set of
accounting records which provides both
financial and cost accounts using a
common input of data for all accounting
purposes.
10
An item of cost directly attributable
to a specific product or service
Bo
x
Definition
•
Direct costs and indirect costs
Direct cost
Indirect cost
An item of expense that cannot be directly
attributed to a specific product or service
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 2
Building up costs of final outputs
the stores account, for recording the
costs of raw materials
•
the work-in-progress account, which
records the costs of items manufactured.
The opening balance and closing
balance on this account at the start and
end of a period represent the total cost
of unfinished production
•
the finished goods account, which
records the cost of finished production
that has not yet been sold to a customer
•
the cost of sales account, which records
the cost of finished production that has
been sold to customers.
KAPLAN PUBLISHING
AC
C
A
G
lo
ba
l
•
Bo
x
The accounts that are used to do this are:
www.ACCAGlobalBox.com
11
Maintaining an appropriate cost accounting system
Documentation for the source data
Document
Labour costs
Expenses
Costs of production
12
Purchase invoice
confirming receipt into stores
of purchase costs
for materials issued to a particular
department
G
lo
ba
l
For materials used
Contains details...
Goods received note
Materials requisition note
Job cost card
Payroll records
materials used in a particular job
total labour costs, analysed between
departments
Job cost cards
labour time/costs on particular jobs
Job sheets/job time cards
time spent on different activities and costs of
the time spent
AC
C
A
For materials
purchased
Bo
x
The details of costs incurred are obtained from source data and recorded in the costing system.
The nature of the source documentation used varies between organisations. Source documents
include:
Purchase invoices
Job cost cards
Production analysis sheets
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 2
•
Definition
In a manufacturing business, the cost units
that are used will depend on the nature of
the manufacturing process.
•
When the firm manufactures different
products, the cost unit will be a unit of
the product, and each product will have a
different cost unit.
G
lo
ba
l
A cost unit is a unit of production or a unit
of activity, in relation to which a cost is
measured. In other words, a cost unit is an
item for which an output cost or an activity
cost is measured.
to monitor changes in costs over time.
Bo
x
Cost units
Cost units are measured for several reasons:
to establish how much it has cost to
produce an item or perform an activity
•
to measure the profit or loss on the item
•
to put a valuation to closing inventory of
the item
•
to compare actual costs of the item with
budgeted costs
•
to plan future costs, by basing future
costs on historical costs
•
to decide on a selling price for the item,
where the selling price is derived by a
‘cost plus’ formula
AC
C
A
•
KAPLAN PUBLISHING
•
When a firm manufactures standard units
in batches, the cost unit will be the batch
of output.
•
When a firm carries out jobs or contracts
for customers, the cost unit will be the
cost of each specific job or contract.
www.ACCAGlobalBox.com
13
Maintaining an appropriate cost accounting system
Cost codes are attached to costs in order to
make them easily identifiable and typically
have three components:
a cost centre/responsibility centre code
(for example, 2 numbers to identify the
canteen and a different two numbers to
represent maintenance etc.)
•
generic or functional code (for example,
2 numbers which represent purchases)
•
a specific item code (for example, oil
might have its own 2 digit code)
AC
C
A
G
lo
ba
l
•
Bo
x
Recording and coding of
costs
The combination of the 6 numbers would
then quickly identify what the cost is for.
14
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
3
G
lo
ba
l
Cost classification
and cost behaviour
In this chapter
Classification of costs.
AC
C
A
•
•
Cost behaviour.
•
Estimating future costs.
•
High-low method.
www.ACCAGlobalBox.com
15
Cost classification and cost behaviour
Direct and indirect costs, prime cost and
overheads
Functional analysis of costs
Categories of functional costs commonly
used are:
•
manufacturing costs
•
administration costs
•
selling and distribution costs (or
marketing costs)
•
possibly, research and development
costs.
G
lo
ba
l
Definition
AC
C
A
Expense type
Another basic classification of costs widely
used in cost accounting is to distinguish
between the cost of materials, such as raw
materials or components, the cost of labour
and other expenses (e.g. overheads).
16
The classification of costs into direct and
indirect costs is a very important technique
which is used to build up the full cost of a
cost unit.
Bo
x
Classification of costs
•
A direct cost is expenditure that can
be directly identified with a specific cost
unit (e.g. materials that go into making
a product and labour that is actually
engaged in manufacturing).
•
Prime cost is the total of direct materials
cost, direct labour cost and (if there are
any) direct expenses.
•
Indirect costs or overheads are
expenditure which cannot be directly
identified with a specific cost unit and
must be ‘shared out’ on an equitable
basis.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
•
The total production cost or full
factory cost of a cost unit is its prime
cost or direct cost, plus its share of
production overheads, consisting of
indirect materials, indirect labour and
indirect expenses.
Analysis of a cost unit
Prime cost
Production overhead
Full factory cost
KAPLAN PUBLISHING
G
lo
ba
l
$
X
X
X
–––
X
X
–––
X
–––
AC
C
A
Direct materials
Direct labour
Direct expenses
Bo
x
Chapter 3
www.ACCAGlobalBox.com
17
Cost classification and cost behaviour
As the activity level increases, fixed costs
remain the same in total but the cost per unit
of activity falls.
Definition
Fixed costs
Output
AC
C
A
Total
cost $
Cost
cost $
unit
G
lo
ba
l
Fixed costs are costs that are not affected
in total by the level of activity, but remain
the same amount regardless of how much
or how little work is done in a period (e.g.
factory rent).
Bo
x
Cost behaviour
Output
18
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 3
Variable costs are costs that change in
direct proportion to the level of activity (e.g.
direct materials costs).
Variable costs
Cost
per $
unit
G
lo
ba
l
Total
cost $
As the level of activity increases, total
variable costs increase in direct proportion to
the increase in activity, but the variable cost
per unit of activity remains the same.
Bo
x
Definition
Output
AC
C
A
Output
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
19
Cost classification and cost behaviour
Definition
Semi-variable costs, also called mixed
costs, are those that have both fixed and
variable elements (e.g. telephone costs,
which consist of a fixed period rental and
charges for calls made).
Total
cost $
G
lo
ba
l
Total
cost $
Stepped-fixed costs, also called step costs or
mixed costs, are costs that are constant for
a range of activity levels, and then change,
and are constant again for another range.
Bo
x
Definition
AC
C
A
Output
With semi-variable costs, as the level of
activity increases, the total cost increases
(not in direct proportion to the level of
activity) and the cost per unit falls.
Stepped-fixed costs
Output
An example of stepped-fixed costs is
supervisors’ salaries.
In cost accounting, it is usual to analyse
semi-variable costs into their fixed and
variable components in order to estimate
future costs.
20
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 3
Cost behaviour analysis has two main
purposes:
•
estimating what future costs should be
•
comparing actual costs with expected
costs (as estimated in a flexed budget).
Estimates of future costs may be shown as a
cost function:
y = a + bx
where
y = total cost
Bo
x
Estimating future costs
a = total fixed cost
G
lo
ba
l
b = variable cost per unit
AC
C
A
Total
cost $
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
x = number of units of output
y=a+bx
=total cost line
radient = b (variable cost
per unit)
a=fixed cost
Volume of activity x
21
Cost classification and cost behaviour
High-low method
Total cost observation (hi h)
Start with the cost information for the
highest activity level and for the lowest
activity level from the data available.
The assumption is that the total cost line
goes through these two points.
•
Since fixed costs are the same at both
activity levels, the difference in total
cost between the highest and the lowest
activity levels must be attributable to
variable costs entirely. The difference
must be the variable cost for the number
of units of activity between the lowest
and the highest points.
•
This allows us to calculate a variable
cost per unit. Having done this, we can
apply the variable cost value to either
the low cost or the high cost data, to
calculate the fixed costs.
Total cost observation (low)
Output
AC
C
A
G
lo
ba
l
•
X
X
Fixed cost
Bo
x
The high-low method estimates fixed and
variable costs by comparing the costs of
the highest and lowest activity levels and
analysing the difference between them.
22
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
4
G
lo
ba
l
Costing of materials
In this chapter
Documentation for materials.
•
Pricing issues of materials.
•
Accounting for materials costs.
•
Inventory losses and waste.
AC
C
A
•
www.ACCAGlobalBox.com
23
Costing of materials
Documentation for materials
Pricing issues of materials
Materials requisition note
authorises the storekeeper to release the
goods
•
acts as a record for updating stores
records.
G
lo
ba
l
•
Stores records
AC
C
A
This is a continual record of each item of
inventory held in store. In a computerised
system a record is held of:
24
FIFO – first in first out
Assume oldest
inventory is used first
•
the quantity and value of inventory
received
•
the quantity and value of inventory
issued
•
the current inventory balance.
LIFO – last in first out
Assume newest
inventory is used first
Bo
x
This records all requests for materials and
serves two purposes:
Inventory
valuation
methods
AVCO – weighted
average cost
Assume inventory is
combined and a new
price is calculated each
time there is a new
delivery
www.ACCAGlobalBox.com
Periodic weighted
average cost
Calculate avera e
price at end of
relevant period
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 4
•
First in first out (FIFO)
AC
C
A
Assume that the oldest inventory is
used first:
Issue of 30 tonnes priced at $40 per
tonne.
•
Last in first out (LIFO)
Assume that the newest inventory is
used first:
Issue of 30 tonnes priced at $45 per
tonne.
KAPLAN PUBLISHING
•
Weighted average cost (AVCO).
Assume that the inventory is
combined and each unit is priced
at the average cost of inventory on
hand:
G
lo
ba
l
There was no inventory of materials on
hand at the start of the month. 50 tonnes
was purchased on the 2nd of the month
for $40 per tonne and a further 40 tonnes
was purchased on the 10th for $45 per
tonne. On the 15th a consignment of
30 tonnes was taken and used in the
manufacturing process.
Bo
x
Example
•
(50 tonnes at $40) + (40 tonnes at
$45) = 90 tonnes costing $3,800 =
$42.22 per tonne.
Issue of 30 tonnes priced at $42.22
per tonne.
Periodic weighted average cost
With the periodic weighted average
cost method of pricing inventory an
average price is calculated at the end
of the period which is then used to
price all issues.
Periodic weighted average price =
Cost of opening inventory + Receipts in the period
Units in opening inventory + Unites received
www.ACCAGlobalBox.com
25
Costing of materials
The relative advantages and disadvantages of FIFO, LIFO and AVCO are therefore discussed
below, particularly in relation to inflationary situations.
Advantages
Disadvantages
FIFO
•
•
Produces out-of-date production costs and
therefore potentially overstates profits.
•
Complicates inventory records as inventory must
be analysed by delivery.
Weighted
average
price
26
•
G
lo
ba
l
•
Produces realistic
production costs
and therefore more
realistic/prudent profit
figures.
Simple to operate –
calculations within the
inventory records are
minimised.
AC
C
A
LIFO
Produces current
values for closing
inventory.
Bo
x
Method
•
Produces unrealistically low closing inventory
values.
•
Complicates inventory records as inventory must
be analysed by delivery.
•
Produces both inventory values and production
costs which are likely to differ from current
values.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 4
Whichever method is adopted it should be
applied consistently from period to period.
Inventory losses and waste
Accounting for materials
costs
Inventory ledger account – item 2345
$
X Issues
X
Receipts
X Closing balance c/d X
––
––
X
X
––
––
X
AC
C
A
Balance b/d
Wastage is usually measured as a
percentage of the quantities of materials
input.
G
lo
ba
l
$
Opening balance b/d
Bo
x
In some manufacturing processes, there
is wastage or loss of inventory. When
wastage is expected during processing, the
department using the materials should allow
for the losses when it orders materials.
Issues of materials are credited to the
stores account with the value or cost
of the materials issued determined by
whichever valuation method is used (FIFO,
LIFO, weighted average cost, etc). The
corresponding double entry is to a work-inprogress account, for direct materials or an
overhead account, for indirect materials.
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
27
Costing of materials
If wastage is 3% of input, output will be
97% of input. In formula terms:
100%
Input = Output x
(100% – Wastage rate percentage)
Input = 500 units x
100
(100 – 3)
AC
C
A
= 515.5 units, say 516 units.
G
lo
ba
l
So if the required output is 500 units, the
input material requirements are:
Bo
x
Example
If wastage is a normal part of the production
process, control measures should be
calculated and actual wastage rates
compared to the control measures, to check
that the wastage rates are as expected. If
wastage is greater or less than expected,
the reasons why this has happened must be
investigated and action taken as necessary.
28
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
5
G
lo
ba
l
Materials inventory control
In this chapter
Monitoring inventory and inventory losses.
•
Costs of inventory holding and stockouts.
•
Economic order quantity (EOQ).
•
Inventory re-order level.
•
Other inventory re-ordering systems.
AC
C
A
•
www.ACCAGlobalBox.com
29
Materials inventory control
Costs of inventory holding
and stockouts
Periodic stocktakes are carried out at a
specified time, for example at the end of the
accounting year. This can be very disruptive
to production, as it may involve closing the
stores for several days. This approach also
means that there are long periods between
stocktakes and substantial discrepancies
may build up.
The total costs associated with inventories
include the following costs:
Bo
x
Monitoring inventory and
inventory losses
purchase costs
•
holding inventory (interest on capital,
the costs of storage space and
equipment, administration costs, and
losses from deterioration, pilferage and
obsolescence)
G
lo
ba
l
•
AC
C
A
Continuous stocktakes involve checking
a proportion of items on a rotating basis. All
items are checked at least once a year but
items which are of high value or are used
frequently can be checked more often.
30
•
ordering inventory (e.g. buyer’s time
spent contacting the supplier, and the
storekeeper’s time spent checking the
goods received)
•
stockouts (i.e. the costs of being without
inventory when it is needed).
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 5
stockouts if the buffer stock is not held;
and
•
the additional inventory holding costs
that arise from having buffer stock.
G
lo
ba
l
•
Lead time is the time gap that arises
between an order being placed and its
eventual delivery.
Bo
x
Buffer stock, or safety stock, is a basic
level of inventory held to cover unexpected
demand or uncertainty of lead time for
an item of inventory. A further problem
for management could be to decide how
much buffer stock to hold for each item of
inventory, to minimise the combined costs of:
How much
to order
When to
re-order
When demand and
lead time are known
with certainty
KAPLAN PUBLISHING
AC
C
A
Three questions about inventory control have
to be resolved:
What inventory
control system
to use
When demand and/or
lead time are not known
with uncertainty
www.ACCAGlobalBox.com
31
Materials inventory control
There is a formula for calculating the
economic order quantity for any item of
inventory, given these assumptions, which is:
Economic order quantity
(EOQ)
Question 1: How much to order?
The economic order quantity for an inventory
item is calculated on the basis of the
following assumptions.
32
Bo
x
Q = EOQ =
2CoD
where
CH
CO is the cost of placing an order of the
inventory item
G
lo
ba
l
Economic order quantity (EOQ) is the
order quantity for an item of inventory that
will minimise the combined costs of inventory
ordering plus inventory holding over a given
period of time, say each year.
There should be no stockout of the item.
•
There is no buffer stock.
•
A new delivery of the inventory item is
received from the supplier at the exact
time that existing inventories run out.
•
The inventory item is used up at an even
and predictable rate over time.
•
The delivery lead time from the supplier
is predictable and reliable.
AC
C
A
•
CH is the annual cost of holding one unit of
the inventory for one year
D
is the annual demand for the inventory
item
Q is the order quantity
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 5
Ordering costs are often based on the
number of orders per year (or month,
or week) which is estimated as: Annual
demand/EOQ.
Recalculate the annual inventory holding
costs, inventory ordering costs and
inventory purchase costs for a purchase
order size that is only just large enough
to qualify for the bulk discount.
4
Compare the total costs when the order
quantity is the EOQ with the total costs
when the order quantity is just large
enough to obtain the discount. Select
the minimum cost alternative.
G
lo
ba
l
EOQ and bulk purchase discounts
3
Bo
x
Holding costs are often based on average
inventory held which is estimated as: EOQ/2.
The EOQ problem can be complicated by
the availability of discounts for large quantity
orders.
AC
C
A
To minimise costs, it is necessary to identify
the order quantity that minimises the total
costs of holding inventory, ordering inventory
and the material purchase costs:
1
Calculate the EOQ, ignoring discounts.
2
If the EOQ is smaller than the minimum
purchase quantity to obtain a bulk
discount, calculate the total for the EOQ
of the annual inventory holding costs,
inventory ordering costs and inventory
purchase costs.
KAPLAN PUBLISHING
5
If there is a further discount available
for an even larger order size, repeat the
same calculations for the higher discount
level.
www.ACCAGlobalBox.com
33
Materials inventory control
Inventory re-order level
Example
Question 2: When to re-order?
The following information relates to
Product X:
Daily demand
Bo
x
When demand and lead time are known
with certainty, the re-order level may be
calculated exactly.
Lead time = 4 days
G
lo
ba
l
Buffer stock
AC
C
A
Re-order level
34
= 50 units
= 10 units
= Buffer stock +
(Demand × Lead
time)
= 10 + (50 × 4)
= 210 units
If it were not company policy to hold
buffer stock, then the re-order level would
simply be (Demand × Lead time) = 200
units.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 5
If demand and lead time are uncertain, the
re-order level is calculated as follows:
Maximum and minimum inventory control
levels
G
lo
ba
l
Minimum inventory control level warns
management that inventory levels are
dangerously low. It is calculated as follows:
Bo
x
Re-order level = Maximum demand
× Maximum lead time.
Re-order level –
(Average demand × Average lead time)
AC
C
A
Maximum inventory control level warns
management that inventory levels are
dangerously high. It is calculated as follows:
Re-order quantity + Re-order level –
(Minimum demand × Minimum lead time)
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
35
Materials inventory control
There are other systems for inventory
re-ordering, in addition to the fixed re-order
level system.
Two-bin system
When this bin in
empty ...
AC
C
A
start usin
this one,
and ...
order more
to refill this one.
The same effect can be had from painting a
line inside a bin and re-ordering whenever
the line starts to show.
36
Periodic review system
G
lo
ba
l
Buy two boxes (or fill two bins) of an item:
This system is unlikely to achieve the lowest
possible inventory costs, but it is useful for
dealing with high volume, low value items
such as nuts and bolts. There is little in the
way of supervision or management review
and so it releases time to focus on the more
important items of inventory.
Bo
x
Other inventory re-ordering
systems
The inventory level is reviewed at fixed
intervals, for example every four weeks.
The inventory in hand is then made up to a
predetermined level, which takes account
of likely demand before the next review and
during the lead time.
This shares the simplicity of the two-bin
method. Suppliers might like the fact that
they receive a regular order, although the
quantity ordered will vary from period to
period.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 5
•
warehousing costs are almost eliminated
•
the quality control function has been
made the responsibility of the supplier
•
problems of obsolescence, deterioration,
theft, cost of capital tied up and all
other costs associated with holding
inventory have been avoided. (However,
the production and unloading facilities
may have to be specially designed or
redesigned.)
G
lo
ba
l
In theory, ‘just-in-time’ (JIT) purchasing
means that inventory will approach zero,
with supplies of goods arriving just in time to
meet demand. However, a JIT purchasing
policy is only possible when suppliers can
be relied on to deliver fresh supplies of an
item at the required time and to the required
quality standard.
The relative costs and benefits of such a JIT
purchasing policy are as follows:
Bo
x
Just-in-time scheduling
In order that such a system can be
successfully adopted, the following features
must be present:
stable, high volume of inventory
consumption
•
co-ordination of the daily production
programmes of the supplier and the
consumer
•
co-operation of the supplier
•
a convenient, reliable transport system,
or the supplier being in close proximity to
the consumer.
AC
C
A
•
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
37
AC
C
A
G
lo
ba
l
Bo
x
Materials inventory control
38
www.ACCAGlobalBox.com
KAPLAN
Downloaded From "http://www.ACCAGlobalBox.com"
6
G
lo
ba
l
Labour costs
Bo
x
chapter
In this chapter
Labour remuneration.
•
Accounting for payroll.
•
Direct and indirect labour costs.
•
Documentation of labour time.
•
Labour turnover.
•
Labour efficiency and utilisation.
AC
C
A
•
www.ACCAGlobalBox.com
39
Labour costs
Accounting for payroll
There are many different ways in which
labour can be paid:
The payroll is usually prepared every
week or month, depending on the pattern
of payment. It calculates each individual
employee’s:
Salary – a fixed amount paid each period
regardless of hours worked or output
produced.
•
Hourly wage – a fixed amount per hour
worked.
•
Time based contract – an hourly wage
paid for a fixed amount of time, with any
‘overtime’ paid at a premium.
gross pay
•
employer’s National Insurance
contribution
Piecework – payment based on volume
of output produced.
•
employer’s pension contribution.
The total cost of labour to the business is the
sum of gross pay employer’s NI and pension
contributions.
AC
C
A
•
•
G
lo
ba
l
•
Bo
x
Labour remuneration
40
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 6
Definition
Direct labour means employees who are
directly involved in producing goods or
services for customers.
Bo
x
Net pay
Direct and indirect labour
costs
G
lo
ba
l
Gross pay
Income tax
Employer’s N.I.
Pension contributions
Other deductions
$
X
(X)
(X)
(X)
(X)
–––
X
–––
Definition
AC
C
A
Indirect labour means employees who are
not directly involved in this work.
KAPLAN PUBLISHING
The allocation of labour costs between direct
and indirect can be calculated in the case
of production workers, some of whose time
may be treated as indirect costs:
•
the costs of idle time (i.e. time paid for
that is non-productive)
•
the costs of overtime premium (i.e. the
additional hourly rate – if any – paid for
overtime)
www.ACCAGlobalBox.com
41
Labour costs
costs of labour time not spent in
production, such as the cost of time
spent on training courses, and the cost
of payments during time off work through
illness.
Overtime premium
AC
C
A
The treatment of overtime worked by direct
workers depends on the reasons why the
overtime was worked.
42
Overtime premium =
Direct cost
Worked at specific request of customer
G
lo
ba
l
Note that all the costs of indirect labour
employees are indirect labour costs.
Basic labour cost =
Direct cost
Bo
x
•
Overtime
Not worked for a specific reason/request
Basic labour cost =
Direct cost
www.ACCAGlobalBox.com
Overtime premium
= Indirect cost
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 6
The most common methods of recording
how much time has been spent on particular
activities, products or jobs are:
time sheets (record of how a person’s
time at work has been spent)
•
job sheets (records the work done –
as well as materials, etc, used – on a
particular job)
cost cards (a card that records the costs
involved in a particular job).
AC
C
A
•
KAPLAN PUBLISHING
Definition
Labour turnover is a measure of the speed
at which employees leave an organisation
and are replaced.
Labour turnover is often calculated as:
G
lo
ba
l
•
Labour turnover
Bo
x
Documentation of labour
time
Average annual number of
leavers who are replaced
x 100%
Average number of employees
Managing labour turnover is important
because of the ‘replacement costs’
associated with replacing staff:
•
advertising
•
employment agency fees
•
time spent interviewing, choosing and
taking on the new employee
•
the costs of training a new employee
www.ACCAGlobalBox.com
43
Labour costs
•
the loss of efficiency whilst new
employees are learning the job
•
the effect on the morale of the existing
work force when labour turnover is high,
leading to a loss of efficiency.
Labour efficiency and
utilisation
improving employee remuneration or
benefits
•
improving the working environment
•
training existing employees and offering
career progression.
AC
C
A
44
Definition
G
lo
ba
l
•
Bo
x
‘Preventative costs’ may also be incurred to
reduce labour turnover:
Two other reasons why a workforce
might produce more or less output than
expected are labour efficiency and labour
utilisation.
Efficiency is the relationship between
actual productivity in a given period and the
standard amount that should be produced in
that time.
If the labour force is inefficient then it is
working more slowly than anticipated or
producing less goods than anticipated in a
set period of time.
Labour efficiency or productivity can be
measured by means of an efficiency ratio:
Average output measured in
standard hours
x 100%
Actual production in hours
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 6
A standard hour is the output expected in
one hour of production at normal efficiency.
Definition
AC
C
A
Actual hours worked
x 100%
Budgeted hours
Labour efficiency and labour utilisation can
be brought together with the production/
volume ratio, which assesses how the
overall production level compares to planned
levels:
Average output measured in
standard hours
Budgeted production hours
KAPLAN PUBLISHING
Production/volume ratio
G
lo
ba
l
Labour utilisation refers to how much
labour time is used, compared to how much
available time was expected. This can be
expressed as a capacity ratio:
Over 100% indicates that overall production
is above planned levels and below 100%
indicates a shortfall compared to plans.
Bo
x
Definition
Capacity
ratio
x
Efficiency
ratio
Definition
Idle time ratio gives an indication of the
percentage of labour hours lost because of
idle time.
Idle time ratio =
Idle hours
x 100%
Total hours available
x 100%
www.ACCAGlobalBox.com
45
AC
C
A
G
lo
ba
l
Bo
x
Labour costs
46
www.ACCAGlobalBox.com
KAPLAN
Downloaded From "http://www.ACCAGlobalBox.com"
7
G
lo
ba
l
Other expenses
Bo
x
chapter
In this chapter
Direct and indirect expenses.
•
Accounting for expenses and expenses costing.
•
Capital and revenue expenditure.
AC
C
A
•
www.ACCAGlobalBox.com
47
Other expenses
To a cost accountant there are three types of
business expenditure. These are materials,
labour and expenses.
Definition
48
Expenses are all business costs that
are not classified as materials or labour
costs.
•
running costs of a machine used only for
one product
•
packaging costs for a product
•
royalties payable per product
•
subcontractors’ fees attributable to a
single product or job
•
the cost of machinery or equipment hired
for a particular job or contract.
G
lo
ba
l
•
Examples of direct expenses:
Bo
x
Direct and indirect expenses
A direct expense is an expense that can
be identified in full with a specific cost
unit.
•
An indirect expense is expenditure
which cannot be identified with a specific
cost unit.
AC
C
A
•
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 7
In a costing system, expenses are not
debited directly to the income statement.
Instead:
direct expenses are debited to the
work-in-progress account
•
indirect expenses are debited to a
production overhead, administration
overhead or sales and distribution
overhead account.
Definition
Capital expenditure is expenditure by a
business on non-current assets.
The accounting treatment of capital
expenditure is that the cost of the noncurrent asset is included in the balance
sheet. The cost of the non-current asset is
written off over its expected useful life as a
depreciation charge in the income statement.
AC
C
A
G
lo
ba
l
•
Capital and revenue
expenditure
Bo
x
Accounting for expenses and
expenses costing
Definition
Revenue expenditure is all expenditure
other than capital expenditure and represents
day-to-day or operating expenses.
Revenue expenditure is treated as an
expense in the income statement in the
period in which the expense is incurred.
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
49
Other expenses
Product units method
Definition
Methods of depreciation include:
straight-line
•
reducing balance
•
machine hours.
1
Compute the “depreciation per unit” as
follows:
Cost less Residual value
Expected total number of units that can
be produced over the life of the asset
G
lo
ba
l
•
The depreciation is computed in two steps:
Bo
x
Depreciation is the measure of the wearing
out, consumption or other reduction in the
useful economic life of a non-current asset.
2
Straight-line method
Cost – Residual value
Expected useful life
AC
C
A
Annual depreciation charge =
Reducing balance method
Calculate is the actual depreciation
expense, which is recorded on the
income statement. Depreciation expense
equals depreciation per unit multiplied by
the number of units produced during the
year.
Annual depreciation charge = Net Book
Value × Percentage depreciation rate
Machine hours method
Rate of depreciation per hour =
Cost – Residual value
Expected machine hours over asset’s life
50
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
8
G
lo
ba
l
Absorption costing
In this chapter
Product costs and service costs.
•
Apportionment and re-apportionment of overhead
costs.
AC
C
A
•
•
The arbitrary nature of overhead apportionments.
•
Overhead absorption.
•
Under and over absorption of overheads.
•
Accounting for production overheads.
•
Non-production overheads.
www.ACCAGlobalBox.com
51
Absorption costing
Product costs and service
costs
G
lo
ba
l
Absorption costing is a method of costing
in which the costs of an item (product or
service or activity) are built up as the sum
of direct costs and a fair share of overhead
costs, to obtain a full cost or a fully-absorbed
cost.
Bo
x
Definition
AC
C
A
Absorption costing involves a three-stage
process to charge overhead costs to
products or services:
•
overhead allocation
•
overhead apportionment
•
overhead absorption.
The first step to dealing with overheads is to
allocate whole items of cost to specific cost
centres where it is appropriate to do so.
52
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 8
Step-down method
G
lo
ba
l
Overhead apportionment is the process
of sharing out overhead costs on a fair
basis and is the second stage in absorption
costing. This is necessary when the
overhead cannot be allocated to specific cost
centres (e.g. a single electricity bill covers
the whole factory).
This method reflects the fact that there
is some interaction between service
departments. Each service department
cost centre is taken in turn, and its costs
are apportioned between the production
cost centres and the remaining service cost
centres.
Bo
x
Apportionment and
re-apportionment of
overhead costs
AC
C
A
Overheads apportioned to service
departments will have to be reapportioned
somehow to production departments.
There are two broad approaches to overhead
re-apportionment:
Direct method
General overheads that have been
apportioned to service department cost
centres are re-apportioned to production cost
centres only.
KAPLAN PUBLISHING
The step-down method is arguably fairer
where service departments provide services
to each other.
Whichever method is used, the end result is
to charge all overhead costs to production
departments. However, the amount of
overheads charged to each production
department will be different depending on
the bases chosen and on whether the direct
method and the step-down method is used.
www.ACCAGlobalBox.com
53
Absorption costing
At the end of the process of allocation and
apportionment of overheads, all overhead
costs have been charged to production cost
centres.
AC
C
A
G
lo
ba
l
The process of apportionment attempts to
be fair, but the selection of the bases for
apportionment is based on judgement and
assumption.
Bo
x
The arbitrary nature of
overhead apportionments
54
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 8
Overhead absorption
Definition
Overhead absorption is the process of
adding overhead costs to the cost of a
product or service, in order to build up a
fully-absorbed product cost or service cost.
Overhead costs
Volume of activity (direct labour hours, machine hours)
Overhead costs for any production
department are the allocated and
apportioned overheads, assembled by the
methods described above.
Exam focus
AC
C
A
G
lo
ba
l
Production overhead costs are absorbed
into product costs on a basis selected by the
organisation. The absorption basis should
be appropriate for the particular products or
services.
An absorption rate is the rate at which
overheads are added to costs:
Bo
x
Definition
The only bases for absorption required for
your syllabus are direct labour hours and
machine hours.
KAPLAN PUBLISHING
In practice, overhead absorption rates are
based on budgeted overhead costs and the
budgeted volume of activity:
Absorption rate =
www.ACCAGlobalBox.com
Budgeted overhead costs
Budgeted volume of activity
55
Absorption costing
Overhead absorption rates are based on
budgeted overhead costs and the budgeted
volume of activity; they are pre-determined.
There are several reasons why a large
amount of under- or over-absorption of
overhead might occur.
actual overhead expenditure will differ
from budgeted overhead expenditure,
and
•
Actual overhead expenditure was much
higher than budgeted, possibly due to
poor control over overhead spending.
•
the actual volume of activity will differ
from the budgeted volume of activity.
•
Actual overhead expenditure was much
less than budgeted, possibly due to good
control over overhead spending.
•
Actual overhead expenditure was much
higher or lower than budgeted, due to
poor budgeting of overhead expenditure.
•
The actual volume of activity was higher
or lower than budgeted, for operational
reasons that the production manager
should be able to explain.
AC
C
A
•
As a consequence, the amount of overheads
charged to product costs will differ from the
actual overhead expenditure.
•
56
We might charge less in overhead
costs to production than the amount of
overhead expenditure actually incurred.
If so, there is under-absorbed or underrecovered overheads.
G
lo
ba
l
In practice, for each accounting period, it is
often the case that:
•
Bo
x
Under and over absorption of
overheads
We might charge more overhead costs to
production than the amount of overhead
expenditure actually incurred. If so, there
is over-absorbed or over-recovered
overheads.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 8
The actual volume of activity was higher
or lower than budgeted, due to poor
budgeting of the volume of activity.
G
lo
ba
l
Over-absorbed overhead is taken to the
costing income statement as an addition to
profit in the period, to compensate for the
fact that the recorded costs of production are
in excess of actual expenditure.
Bo
x
•
AC
C
A
Under-absorbed overhead is shown as
a separate item in the costing income
statement. Since production has been
charged with less overheads than the
amount of overheads incurred, under
absorption is shown as a cost in the income
statement, reducing the profit.
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
57
Absorption costing
If a manufacturing business maintains
cost accounts in a cost ledger, overheads
are accounted for within the double entry
bookkeeping system of the cost ledger.
•
The under- or over-absorbed overhead
account. This account collects under/
over-absorption balances from the
production overhead account prior to
write off to the income statement.
The production overhead account.
This account is debited with the actual
cost of indirect materials, labour and
expenses and credited with overhead
absorbed to production. The balance
on this account represents over- or
under-absorption and is either written
off directly to the income statement or
is passed to an under/over-absorption
account.
AC
C
A
•
The work-in-progress account. This
account is debited with production
overhead absorbed. The full cost of
production is therefore built up on the
debit side of this account.
G
lo
ba
l
Three accounts are particularly relevant to
accounting for production overheads:
•
Bo
x
Accounting for production
overheads
58
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 8
In a system of absorption costing, it is quite
usual for administration overheads and sales
and distribution overheads to be treated as
period costs and written as a charge to the
income statement, instead of being added to
the cost of cost units.
Bo
x
Non-production overheads
G
lo
ba
l
However, it is also possible to calculate a
full cost of sale by absorbing non-production
overheads into costs.
Administration overheads might be
absorbed into unit costs as a percentage
of full production cost.
•
Sales and distribution overheads might
be absorbed into unit costs as either
a percentage of sales value, or as a
percentage of full production cost.
KAPLAN PUBLISHING
AC
C
A
•
www.ACCAGlobalBox.com
59
AC
C
A
G
lo
ba
l
Bo
x
Absorption costing
60
www.ACCAGlobalBox.com
KAPLAN
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
9
G
lo
ba
l
Marginal costing
and absorption costing
In this chapter
Full cost and marginal cost.
AC
C
A
•
•
Contribution.
•
Profit statements under absorption and marginal
costing.
•
Comparison of the methods.
www.ACCAGlobalBox.com
61
Marginal costing and absorption costing
Full cost and marginal cost
Contribution
In marginal costing, fixed manufacturing
overheads are not absorbed into cost units.
Inventory is valued at marginal or variable
production cost. All fixed overheads,
including fixed manufacturing overheads, are
treated as period costs and are charged in
the income statement of the period in which
the overheads are incurred.
Contribution = Sales – Variable cost of sales
Profit = Contribution – Fixed costs
G
lo
ba
l
Bo
x
Decisions about the implications of many
business decisions can be simplified by
thinking in terms of contribution.
AC
C
A
The inventory valuation will be different for
marginal and absorption costing. Under
absorption costing the inventory value
will include variable and fixed production
overheads whereas under marginal costing
the inventory value will only include variable
production overheads.
62
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 9
The choice made will affect:
Because inventory is valued differently under
the two systems, any change in inventory
will create a difference in the reported profits
between the two systems.
Basic rules:
•
If inventory levels are rising:
AC profit > MC profit
G
lo
ba
l
Absorption costing must be used to provide
inventory valuations for statutory financial
statements. However, either marginal or
absorption costing can be useful for internal
management reporting.
Reconciliation of profits
Bo
x
Profit statements under
absorption and marginal
costing
•
the way in which the profit information is
presented, and
•
the level of reported profit, but only if
sales volumes do not exactly equal
production volumes (so that there is a
difference between opening and closing
inventory values).
AC
C
A
•
If inventory levels are falling:
AC profit < MC profit
To reconcile the profits between the systems
we can make the following adjustment:
£
AC Profit
(Increase)/ decrease in inventory
x fixed o/h per unit
MC Profit
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
X
(X)/X
X
63
Marginal costing and absorption costing
Comparison of the methods
In an exam question, if you are given the
profit under one system and the change in
inventory, you can use this reconciliation
technique to quickly determine the profit
under the alternative system.
Absorption costing
Advantages
Disadvantages
Improved long-term
pricing
More difficult
Bo
x
Exam focus
G
lo
ba
l
Ensures prices
cover all costs
Better cost control
Encourages
over-production
Requires arbitrary
cost apportionments
AC
C
A
Consistent with
financial reporting
Marginal costing
Advantages
Disadvantages
Better for shortterm decision
making
Shouldn’t be used
for long term-pricing
Simpler
64
www.ACCAGlobalBox.com
Can’t be used for
external reporting
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
10
G
lo
ba
l
Job costing and
batch costing
Bo
x
chapter
In this chapter
Specific order costing.
AC
C
A
•
•
Job costing.
•
Batch costing.
www.ACCAGlobalBox.com
65
Job costing and batch costing
The main types of cost unit are as follows:
There are two main types of costing system:
Specific order costing, where the
costs of distinct products or services
are collected. Individual cost units
are different according to individual
customer’s requirements. The main
examples of specific order costing are
job costing and batch costing.
•
Continuous costing, where a series of
similar products are produced. Costs
are collected and averaged over the
number of products or services produced
to arrive at a cost per unit. The main
examples of continuous costing are
process costing and service costing
which are considered in later chapters.
AC
C
A
The cost units of different organisations will
be of different types and this will tend to
necessitate different costing systems.
66
Individual
products
desi ned and
produced for
individual
customers
Groups of
different
products,
possibly in
different
styles, sizes
or colours,
produced
to be held
in inventory
until sold
Many units
of identical
products
produced
from a sin le
production
process.
These units
will be held
in inventory
until sold
Each
individual
product is a
cost unit
Each batch is
a cost unit
Each batch
from the
process is a
cost unit
Job
costing
Batch
costing
Process
costing
G
lo
ba
l
•
Bo
x
Specific order costing
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 10
Job costing
Batch costing
Definition
Definition
Each batch is very similar to a job and in
exactly the same way as in job costing the
costs of that batch are gathered together on
some sort of batch cost card.
G
lo
ba
l
All of the actual costs incurred in a job are
eventually recorded on a job cost card.
A batch is a group of identical but separately
identifiable products that are all made
together.
Bo
x
A job is an individual product designed and
produced as a single order for individual
customers.
AC
C
A
As well as recording the job costs on the job
cost card they must also be recorded in the
cost ledger accounts. Each job will have its
own job ledger account to which the costs
incurred are all debited.
Typically, the profit added on is a standard
percentage of the total cost (a profit mark-up)
or a standard percentage of sales price (a
profit margin).
This form of pricing is known as cost-plus
pricing.
KAPLAN PUBLISHING
These costs will be the materials input into
the batch, the labour worked on the batch,
any direct expenses of the batch and the
batch’s share of overheads.
Cost of a cost unit
Cost per unit =
www.ACCAGlobalBox.com
Total batch cost
Number of units in batch
67
AC
C
A
G
lo
ba
l
Bo
x
Job costing and batch costing
68
www.ACCAGlobalBox.com
KAPLAN
Downloaded From "http://www.ACCAGlobalBox.com"
11
G
lo
ba
l
Process costing
Bo
x
chapter
In this chapter
Features of process costing.
•
Losses.
•
Abnormal gain.
•
The nature of joint products and by-products.
•
Costing with joint products.
•
Costing with by-products.
•
Evaluating the benefit of further processing.
AC
C
A
•
www.ACCAGlobalBox.com
69
Process costing
Definition
Process costing is a method of costing
used in industries including brewing, food
processing, quarrying, paints, chemicals and
textiles.
•
Total costs therefore build up as the
output goes through each successive
processing stage.
Bo
x
Features of process costing
X=
70
Expected process
Number of units in batch
G
lo
ba
l
The cost per unit of finished output (X) is:
Process costs consist of direct materials,
direct labour and production overheads.
•
Costs of conversion, are the labour costs
of the process plus the overheads of the
process.
•
When processing goes through several
successive processes, the output from
one process becomes an input direct
material cost to the next process.
AC
C
A
•
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 11
Valuation of normal loss
If losses are a regular and expected aspect
of the process then it is appropriate to
calculate a cost per unit, based on the
expected output from the process.
•
If units of normal loss have no scrap
value, their value or cost is nil.
•
If units of normal loss have a scrap
value, the value of this loss is its scrap
value, which is set off against the cost of
the process. In other words, the cost of
finished output is reduced by the scrap
value of the normal loss.
Definition
AC
C
A
Definition
G
lo
ba
l
Normal loss is the expected amount of loss
in a process. It is the level of loss or waste
that management would expect to incur
under normal operating conditions.
Abnormal loss is the amount by which
actual loss exceeds the expected or normal
loss in a process. It can also be defined
as the amount by which actual production
is less than normal production. Normal
production is calculated as the quantity of
input units of materials less normal loss.
KAPLAN PUBLISHING
Bo
x
Losses
Valuation of abnormal loss
Abnormal loss is given a cost. The cost of a
unit of abnormal loss is the same as a cost
of one unit of good output from the process.
The cost of abnormal loss is treated as a
charge against profit in the period it occurs.
In the cost accounts, abnormal loss is
accounted for in an abnormal loss account.
The double entry transactions are:
•
Debit
Abnormal loss account
•
Credit
Process account
www.ACCAGlobalBox.com
71
Process costing
Any scrap value of an abnormal loss is set
off against the amount to be written off to the
income statement.
Abnormal gain
Definition
Abnormal gain is the amount by which actual
output from a process exceeds the expected
output. It is the amount by which actual loss
is lower than expected loss.
Bo
x
with the cost of the abnormal loss – the
balance on the abnormal loss account is
transferred to the income statement at the
end of the period.
G
lo
ba
l
In the cost accounts, abnormal gain is
recorded as:
•
Debit
Process account
•
Credit
Abnormal gain account
AC
C
A
with the value of the abnormal gain
72
If loss has a scrap value
•
Debit
Abnormal gain account
•
Credit
Normal loss account
with the scrap value of the abnormal gain.
This is income that has not been earned
because loss was less than normal.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 11
The process account
The entries in the process account are
summarised as follows:
Units
$
X
X
Direct labour
Process overhead
X
–––
X
–––
AC
C
A
Abnormal gain
KAPLAN PUBLISHING
Finished goods
G
lo
ba
l
Direct material
Bo
x
PROCESS A/C
Units
$
X
X
X
Normal loss
X
X
X
Abnormal loss
X
X
–––
X
–––
–––
X
–––
X
–––
X
–––
www.ACCAGlobalBox.com
73
Process costing
Definition
Definition
Up to the separation point, the processing
costs are common to all the products that are
subsequently produced. A task in process
costing is to share the common process
costs up to separation point between the
different products.
G
lo
ba
l
Joint products are separate products
that emerge from a single process. Each
of these products has a significant sales
value to the organisation.
process. Items produced at the separation
point are either sold in their current form or
put through further processing before sale.
Bo
x
The nature of joint products
and by-products
AC
C
A
A by-product is a product that is produced
from a process, together with other products,
that is of insignificant sales value.
Quite often, different products produced
by a single process might be given further
separate processing, before they are ready
for sale.
The separation point, or split-off point,
in a process manufacturing operation is
the point during manufacture where two or
more products are produced from a common
74
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 11
Definition
Joint costs or common process costs are
the costs incurred in a process that must be
split or apportioned amongst the products
produced by the process.
G
lo
ba
l
When two or more joint products are
produced in a common process the common
costs incurred pre-separation can be
apportioned in proportion to:
A joint product might not have a sales value
at the point of separation, but might need
to be processed further before it can be
sold. It might be necessary to apportion
costs between joint products on the basis of
their eventual sales value minus the further
processing costs necessary to get them
ready for sale. In other words, the costs
might have to be apportioned on the basis of
their net realisable value.
Bo
x
Costing with joint products
the physical quantity, volume or
weight of each product, or
•
their relative sales values.
AC
C
A
•
Apportioning costs on the basis of sales
value overcomes the problem that the joint
products might have different physical
characteristics (e.g. a process might yield
both a gas and a liquid).
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
75
Process costing
Method 1. Treat the income from the by-product
as incidental income, and add it to sales in the
income statement
Accounting treatments
for by-products
AC
C
A
G
lo
ba
l
The costing treatment of by-products is
different from the costing treatment of joint
products. Since by-products have very little
sales value, it is pointless to try working out
a cost and a profit for units of by-product.
By-products are incidental output, not main
products.
Bo
x
Costing with by-products
76
Method 2. Instead of addin the income from
by-product sales to total sales income in the
income statement, deduct the sales value of the
by-product from the common processin costs.
The pre-separation costs for apportionin between
joint products is therefore the actual pre-separation
costs minus the sales value of the by-product
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 11
AC
C
A
G
lo
ba
l
To evaluate processing of the individual
products it is necessary to identify the
incremental costs and incremental
revenues relating to that further processing,
i.e. the additional costs and revenue
brought about directly as a result of that
further processing.
Bo
x
Evaluating the benefit of
further processing
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
77
AC
C
A
G
lo
ba
l
Bo
x
Process costing
78
www.ACCAGlobalBox.com
KAPLAN
Downloaded From "http://www.ACCAGlobalBox.com"
12
G
lo
ba
l
Service costing
Bo
x
chapter
In this chapter
When to use service costing.
•
Service costs and cost units.
•
Service costing for internal services.
AC
C
A
•
www.ACCAGlobalBox.com
79
Service costing
Service costs and cost units
Service costing is used when there is no
physical product, to obtain a cost for each
unit of service provided. Note that inventory
of services cannot be held.
A major problem in service industries is the
selection of a suitable unit for measuring
the service, i.e. in deciding what service is
actually being provided and what measures
of performance are most appropriate to the
control of costs. Some cost units used in
different activities are given below.
Services can be:
External services to a customer, for
which a price is charged. Examples are
the provision of telephone and electricity
services, consultancy, auditing services
by a firm of accountants, hotel services,
travel services and so on.
G
lo
ba
l
•
Bo
x
When to use service costing
80
Internal services within an organisation
can be any activity performed by one
department for another, such as machine
repairs, services of an IT department,
payroll activities and so on.
AC
C
A
•
Service
Cost unit
Electricity
generation
Kilowatt hours
Canteens and
restaurants
Meals served
Carriers
Miles travelled: ton-miles
carried
Hospitals
Patient-days
Passenger
transport
Passenger-miles: seatmiles
Accountancy
Accountant-hour (man
hour)
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 12
Internal services may be set up as
profit centres rather than cost centres
to encourage managers to be efficient
and to enable comparison with external
suppliers. For example the IT department,
legal services and building repairs could
all be operated as profit centres charging
internal departments for their services and
calculating the notional profit made on their
activities.
G
lo
ba
l
Costs will be classified under appropriate
headings for the particular service. This will
involve the issue of suitable cost codes to
be used in the recording and, therefore, the
collection of costs.
Service costing for internal
services
Bo
x
Where cost units are in two or more parts,
such as patient-days or passenger miles
these are known as composite cost units.
AC
C
A
In service costing it is often important to
classify costs into their fixed and variable
elements. Many service applications involve
high fixed costs and the higher the number
of cost units produced the lower the fixed
costs per unit.
KAPLAN PUBLISHING
Costs of internal services can be determined
in the same way as for service organisations
and may be used to measure the efficiency
of departments or compare their costs with
using sub-contractors.
www.ACCAGlobalBox.com
81
AC
C
A
G
lo
ba
l
Bo
x
Service costing
82
www.ACCAGlobalBox.com
KAPLAN
Downloaded From "http://www.ACCAGlobalBox.com"
13
G
lo
ba
l
CVP analysis
Bo
x
chapter
In this chapter
Costs, volumes and profits.
•
Uses of CVP analysis.
•
Break-even charts.
AC
C
A
•
www.ACCAGlobalBox.com
83
CVP analysis
Definition
Assumptions
84
Unit contribution = Selling price per unit
– Variable costs per unit.
•
Total contribution = Volume of sales in
units × (Unit contribution); or
= Total sales revenue – Total variable
cost; or
= Total sales revenue × Contribution/
Sales ratio
G
lo
ba
l
Cost-volume-profit (CVP) analysis is a
technique for analysing how costs and profits
change with the volume of production and
sales. It is also called break-even analysis.
•
Bo
x
Costs, volumes and profit
•
Short term
•
Constant selling prices
•
Constant variable costs per unit
•
Constant contribution per unit
•
Constant fixed costs – not stepped
•
Sales = production
•
The objective is to maximise profit
Contribution/Sales ratio or C/S ratio
= Contribution per unit/Sales price per
unit; or
= Total contribution/Total sales revenue
AC
C
A
•
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 13
Break-even point
CVP analysis is used widely in preparing
financial reports for management. It is
a simple technique that can be used to
estimate profits and make decisions about
the best course of action to take.
At break-even point, total contribution is just
large enough to cover fixed costs. In other
words, at break-even point:
Total contribution = Fixed costs
The break-even point in units of sale can
therefore be calculated as:
G
lo
ba
l
Estimatin future
profits
Bo
x
Uses of CVP analysis
Break-even point
in units of sale =
Applications
of CVP
analysis
Calculatin sales
required to achieve
tar et profits
KAPLAN PUBLISHING
Calculatin
break-even
points
AC
C
A
Determinin
sales
prices
for
products
Fixed costs
Contribution per unit
It is also possible to calculate the break-even
point in terms of sales revenue:
Fixed costs
Break-even point in sales
revenue =
C/S ratio
Analysin
mar in of safety
www.ACCAGlobalBox.com
85
CVP analysis
Margin of safety
Example
Budgeted sales – Breakeven units
Budgeted sales
x 100
AC
C
A
Margin of safety
86
:
:
:
:
Break-even volume =
G
lo
ba
l
=
Budgeted sales
Selling price
Variable costs
Fixed costs
Bo
x
The margin of safety explains by how much
sales can fall below budget before a loss
would occur. It is normally calculated as a
percentage as follows:
80,000 units
$8
$4 per unit
$200,000 pa
200,000
8–4
= 50,000 units
= (80,000 – 50,000)
units
= 30,000 units or
37½% of budget
The margin of safety may also be expressed
as a percentage of actual sales or of
maximum capacity.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 13
Target profit
Target contribution =
Fixed costs + Target profit
Solution
Contribution = $1.60 per cup
Bo
x
Target contribution = $800 + $600 =
$1,400 per week
AC
C
A
A coffee shop sells a single type of coffee
for $2.00 per cup. The variable cost is
$0.40 per cup. Fixed costs are $800 per
week.
What is the target sales volume and
target sales revenue if the shop wishes to
make a profit of $600 per week?
KAPLAN PUBLISHING
Contribution per unit
= $1,400 / $1.60 = 875 cups per week
C/S ratio =
Example
Target contribution
Target sales volume =
G
lo
ba
l
CVP analysis can also be used to calculate
the volume of sales that would be required
to achieve a target level of profit. To achieve
a target profit, the business will have to earn
enough contribution to cover all of its fixed
costs and then make the required amount of
profit.
1.60
2.00
= 0.8
Target sales volume =
=
Target contribution
C/S ratio
$1,400
0.8
= $1,750
www.ACCAGlobalBox.com
87
CVP analysis
Profit/volume graph
CVP analysis can be presented in the form
of a diagram or graph, as well as in figures.
A graphical presentation of CVP analysis can
be made in either:
A profit/volume graph is an adaptation of
a break-even chart which makes it easier to
determine the profit or loss at each volume
of sales.
a conventional break-even chart; or
•
a profit/volume chart.
Conventional break-even chart
Cost and
revenue in $
AC
C
A
Mar in
of
safety
88
Break-even
point
Sales
revenue
Total
costs
0
Profit
$
G
lo
ba
l
•
Bo
x
Break-even charts
Break
even
point
Variable
costs
Fixed
costs
Bud eted Output
or actual (units)
sales
Level of activity or sales
Loss
$
The x axis represents sales volume, in units or $.
The y axis represents loss or profit.
The x axis cuts the y axis at break-even
point (profit = 0). Losses are plotted below
the line and profits above the line.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
14
G
lo
ba
l
ecision making
Bo
x
chapter
In this chapter
Decision making and relevant cost information.
•
Limiting factors and limiting factor decisions.
•
Make-or-buy decisions.
•
Other types of decision.
•
Identifying relevant costs.
AC
C
A
•
www.ACCAGlobalBox.com
89
Decision making
90
non-cash charges such as
depreciation of non-current assets
–
notional costs such as notional
interest charges
–
absorbed fixed overheads. Cash
overheads incurred are relevant
if they change as a result of the
decision and are future cash flows,
but absorbed overheads are a
notional accounting cost. Absorbed
fixed overheads are not avoided as
a result of a decision but will have to
be reallocated elsewhere.
G
lo
ba
l
For decision making, it is necessary to
identify the costs and revenues that will be
affected as a result of taking one course of
action rather than another. The costs that
would be affected by a decision are known
as relevant costs.
–
Bo
x
Decision making and
relevant cost information
A relevant cost is an incremental
cost. This means that it will change as
a direct consequence of the decision.
Thus relevant costs are often calculated
as any change in contribution plus any
change in specific fixed costs.
•
A relevant cost is a future cost. This
means that any costs that have been
incurred in the past (sunk costs) cannot
be relevant to a decision.
•
A relevant cost is a cash flow. Any
‘costs’ that are not cash flow items are
not relevant. These include:
AC
C
A
•
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 14
Sunk costs
Example
Definition
Definition
G
lo
ba
l
Opportunity costs
AC
C
A
Opportunity cost is the value of the benefit
forgone from the best alternative course of
action.
KAPLAN PUBLISHING
Bo
x
Sunk costs are costs that have already
been incurred or committed. They cannot be
relevant costs.
A sales manager can choose between
spending the remainder of the annual
sales budget on a mail shot, which will
probably increase sales by 5%, or a radio
advert, which will probably increase sales
by 11%. The opportunity cost of the radio
advert is the 5% gain from the mail shot
(although that is less attractive than the
11% from the radio advert).
Avoidable and unavoidable costs
•
If a cost can be avoided, it is a relevant
cost because a decision will be taken
that will prevent the cost from occurring.
•
If a cost is unavoidable, it cannot be
relevant to a decision, because it will be
incurred anyway.
www.ACCAGlobalBox.com
91
Decision making
A resource in short supply is called a limiting
factor, because it sets a limit on what can be
achieved by an organisation.
Ranking approach
92
When a business is considering whether
or not to buy items externally rather than
make them internally, the relevant financial
information is a comparison of the costs of
making and buying.
G
lo
ba
l
With this approach, products are ranked in
order of their contribution per unit of limiting
factor.
Make-or-buy decisions
Bo
x
Limiting factors and limiting
factor decisions
Identity scarce resource
2
Calculate contribution per unit of product
3
Calculate scarce resource units used by products
4
Calculate contribution per unit of scarce resource
5
Rank products (hi hest = 1st)
6
Allocate scarce resources accordin to rankin
AC
C
A
1
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 14
Utilisation of spare capacity
Relevant costs should be applied to any type
of decision. For example:
Where production is below capacity,
opportunities may arise for sales at a
specially reduced price, for example, export
orders or manufacturing under another brand
name. Such opportunities are worthwhile if
the answer to two key questions is ‘Yes’:
decisions about volume and cost
structure changes
•
utilisation of spare capacity
•
special contract pricing
•
closure of a business segment.
Decisions about volume and cost
structure changes
AC
C
A
Management will require information to
evaluate proposals aimed at increasing
profit by changing operating strategy. The
cost accountant will need to show clearly
the effect of the proposals on profit by pinpointing the changes in costs and revenues
and by quantifying the margin of error which
will cause the proposal to be non-viable.
KAPLAN PUBLISHING
•
Is spare capacity available?
•
Does additional revenue (Units ×
Price) exceed additional costs (Units
× Relevant variable cost, plus any
incremental fixed cost expenditure)?
G
lo
ba
l
•
Bo
x
Other types of decision
Special contract pricing
A business which produces to customer’s
orders may be working to full capacity. Any
additional orders must be considered on the
basis of the following questions:
•
What price must be quoted to make the
contract profitable?
•
Can other orders be fulfilled if this
contract is accepted?
www.ACCAGlobalBox.com
93
Decision making
Closure of a business segment
G
lo
ba
l
Part of a business may appear to be
unprofitable. The segment may, for example,
Bo
x
In such a situation the limiting factor needs
to be recognised so that the contract price
quoted will at least maintain the existing rate
of contribution per unit of limiting factor.
be a product, a department or a channel of
distribution. In evaluating closure the cost
accountant should identify:
94
loss of contribution from the segment
•
savings in specific fixed costs from
closure
•
penalties, e.g. redundancy,
compensation to customers
•
alternative use for resources released
•
non-quantifiable effects.
AC
C
A
•
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 14
Identifying relevant costs
The relevant costs of materials
Will they
be replaced
AC
C
A
Yes
Replacement
cost
Yes
Contribution from
alternative use
KAPLAN PUBLISHING
No
Are materials already
in inventory?
G
lo
ba
l
Yes
Bo
x
In any decision situation the cost of materials relevant to a particular decision is their opportunity
cost. This can be represented by a decision tree.
Cost of
purchase
No
Will they be used
for other purposes
No
Net realisable value
www.ACCAGlobalBox.com
95
Decision making
The relevant cost of labour
Does spare
capacity exist?
Yes
AC
C
A
Cost of hirin
96
Can extra
employees
be hired?
G
lo
ba
l
Nil cost unless overtime
worked or extra labour
hired, when cash outlay
No
Bo
x
Yes
No
Contribution from
alternative products which
must be abandoned to
create spare capacity
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
15
G
lo
ba
l
iscounted cash flow
and capital expenditure appraisal
In this chapter
Investment appraisal.
•
Payback method of appraisal.
•
Time value of money.
•
Interest.
•
Discounted cash flow (DCF).
•
Net present value method (NPV).
•
Annuities and perpetuities.
•
Internal rate of return method (IRR).
•
Discounted payback method.
•
Using NPV, IRR and payback.
AC
C
A
•
www.ACCAGlobalBox.com
97
Discounted cash flow and capital expenditure appraisal
Definition
Capital investment appraisal is an analysis of
the expected financial returns from a capital
project over its expected life.
Internal rate
of return (IRR)
AC
C
A
Capital expenditure
appraisal methods
G
lo
ba
l
Net present
value (NPV)
Payback
98
A common feature of all four methods is
that they analyse the expected cash flows
from the capital project, not the effects of the
project on reported accounting profits.
Bo
x
Investment appraisal
Discounted
payback
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 15
Definition
The payback period is calculated simply as:
Payback period =
Disadvantages
Simple/easy to
understand
Ignores cash-flows
post payback
Concentrates on
earlier flows to take
account of risk
Doesn’t explain
the impact on
shareholder wealth
Useful when short
of cash
Difficult to set a
target
G
lo
ba
l
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.
Advantages
Bo
x
Payback method of appraisal
Initial payment
Annual cash inflow
It ignores the time
value of money
AC
C
A
It is normally assumed that cash flows each
year occur at an even rate throughout the
year. A payback period might not be an
exact number of years.
The simplest way of calculating payback is
probably to set out the figures in a table.
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
99
Discounted cash flow and capital expenditure appraisal
Time value of money
Interest
The time value of money arises for three
reasons:
100
•
Impact of inflation – funds received today
will buy more than the same amount a
year later, as prices will have risen in the
meantime.
•
Risk – the earlier cash flows are due to
be received, the more certain they are
– there is less chance that events will
prevent payment.
Bo
x
Consumption Preferences – there is
a strong preference for the immediate
rather than delayed consumption.
Investors would typically prefer to receive
returns sooner rather than later.
When money is
invested it earns
interest
AC
C
A
G
lo
ba
l
•
Principal = money
invested or borrowed
Simple – interest
earned each year but
is not added to the
principal
www.ACCAGlobalBox.com
When money is
borrowed, interest is
payable
Interest
Compound – interest
earned each year
is added to the
principal
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 15
Compound interest formula:
Discounted cash flow (DCF)
S = P(1 + r)n
Bo
x
S = amount at end of the nth year invested
at a rate of r%.
Discounted cash flow, or DCF, is an
investment appraisal technique that takes
into account both the timing of cash flows
and also the total cash flows over a project’s
life.
G
lo
ba
l
Definition
AC
C
A
A present value is the amount that would
need to be invested now to earn the future
cash flow, if the money is invested at the
‘cost of capital’.
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
101
Discounted cash flow and capital expenditure appraisal
Exam focus
AC
C
A
G
lo
ba
l
In the exam, relevant discount factors will be
provided in questions.
Bo
x
To calculate a present value for a future
cash flow, you simply multiply the future
cash flow by the appropriate discount
factor.
102
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 15
Net present value method
(NPV)
•
The net present value or NPV method of
DCF analysis is to calculate a net present
value for a proposed investment project.
Bo
x
Definition
If the NPV is negative, it means that the
cash inflows from a capital investment
will yield a return below the cost of
capital. The project should therefore be
rejected on a financial basis.
The NPV is the value obtained by
discounting all of the cash outflows and
inflows for the project capital at the cost of
capital, and adding them up.
Advantages
Disadvantages
It takes account of
the time value of
money
Complex
If the NPV is exactly zero, the cash
inflows from a capital investment will
yield a return exactly equal to the cost
of capital. The project is therefore just
acceptable on a financial basis.
G
lo
ba
l
•
•
AC
C
A
Cash outflows are negative and inflows are
positive values. The sum of the present
value of all of the cash flows from the project
is the ‘net’ present value amount.
If the NPV is positive, it means that the
cash inflows from a capital investment
will yield a return in excess of the cost of
capital. The project should therefore be
accepted on a financial basis.
KAPLAN PUBLISHING
It can easily account
for risk
www.ACCAGlobalBox.com
It only considers
the long-term, so it
may lead to shortterm demotivation
103
Discounted cash flow and capital expenditure appraisal
Annuities and perpetuities
Definition
PV =$500 x
Example
AC
C
A
Find the present value of $500 payable
for each of three years given a discount
rate of 10%. Each sum is due to be paid
annually in arrears.
Solution
Annuities tables avoid the need to
calculate the value of each year’s
cash flow separately. For example, the
discount factor appropriate to a three
year annuity at 10%, is 2.487, so the PV
of $500 for 3 years at a cost of capital of
10% is therefore $500 × 2.487 = $1,243.
G
lo
ba
l
For example, if there is a cash flow of $3,000
from Year 1 to Year 5, this is an annuity.
=$454 + $413 + $376 = $1,243
Bo
x
An annuity is a constant annual cash flow
over a number of years.
1
1
1
+ $500 x
+ $500 x
1.13
1.1
1.12
The PV can be found from three separate
calculations of the present value of each
annual cash flow.
Definition
A perpetuity is a constant annual cash flow
that will continue ‘for ever’.
The present value of an annuity, A,
receivable in arrears in perpetuity given a
discount rate, r, is given as follows:
PV perpetuity =
104
www.ACCAGlobalBox.com
Annual cash flow
A
=
Discount rate (as a decimal)
r
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 15
Definition
The internal rate of return (IRR) method of
DCF analysis is to calculate the exact DCF
rate of return that the project is expected to
achieve. This is the cost of capital at which
the NPV is zero.
AC
C
A
G
lo
ba
l
The present value of $5,000 receivable
annually in arrears at a discount rate of
8% is:
$5,000
= $62,500
0.08
Internal rate of return
method (IRR)
Bo
x
Example
KAPLAN PUBLISHING
If the expected rate of return (known as the
internal rate of return or IRR, and also as
the DCF yield) is higher than a target rate
of return, the project is financially worth
undertaking.
The interpolation method produces an
estimate of the IRR.
www.ACCAGlobalBox.com
105
Discounted cash flow and capital expenditure appraisal
Advantages
Disadvantages
Takes account of
the time value of
money
It is a relative
measure
Provides sensitivity
information
Can’t be used to
compare projects
The answer is well
understood
G
lo
ba
l
Step 1 Calculate two net present values for
the project at two different costs of
capital. Ideally, you should use one
cost of capital where the NPV is
positive and the other cost of capital
where the NPV is negative, although
this is not essential.
Bo
x
The steps in this method are as follows.
IRR = A% +
AC
C
A
Step 2 We can then estimate the cost
of capital at which the NPV is 0.
Ideally, our two guesses will give
NPV as close as possible to zero, so
that the error in this estimation can
be minimised.
P
x (B – A)%
(P+N)
NPV at A% = + $P
NPV at B% = – $N
106
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 15
Using NPV, IRR and payback
The discounted payback method of
capital investment appraisal is similar to the
payback method, except that the payback
period is measured with present values of
cash flows.
It is important to recognise that all of these
methods of appraisal use the expected cash
flows from a capital investment. These are
the relevant costs and revenues from the
investment. For decision-making purposes,
relevant costs and cash flows should always
be used, not figures for accounting profits.
AC
C
A
G
lo
ba
l
Bo
x
Discounted payback method
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
107
AC
C
A
G
lo
ba
l
Bo
x
Discounted cash flow and capital expenditure appraisal
108
www.ACCAGlobalBox.com
KAPLAN
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
16
G
lo
ba
l
The nature of cash and cash flows
In this chapter
Cash and the cash cycle.
•
Sources and uses of cash.
•
Main types of cash receipts and payments.
•
Cash flow and profit.
•
Liquidity.
•
Cash accounting and accruals accounting.
AC
C
A
•
www.ACCAGlobalBox.com
109
The nature of cash and cash flows
Cash and the cash cycle
Cash cycle and operating cycle
Cash can be defined as money, in the form
of notes and coins.
The cash flow cycle is the period of time
required for an organisation to receive
invested funds back in the form of cash.
Bo
x
It does not include:
•
long-term borrowing
•
money owed by customers
•
inventory (inventories).
Receives
oods
AC
C
A
long-term deposits
G
lo
ba
l
Orders
oods
•
110
www.ACCAGlobalBox.com
Receives Pays
invoice invoice
Sells product
on credit
Receives cash
from customers
Operatin cycle
Cash cycle
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 16
Sources and uses of cash
Sources of cash
Uses of cash
Financing activities
Financing activities
•
Increase in long-term debt
•
•
Increase in equity
•
•
Increase in current liabilities
•
Bo
x
Decrease in equity
G
lo
ba
l
Decrease in current liabilities
Investing activities
Investing activities
Decrease in current assets
•
Decrease in fixed assets (non-current
assets)
AC
C
A
•
Operating activities
Decrease in long-term debt
•
Increase in current assets
•
Increase in fixed assets (non-current
assets)
Operating activities
•
Collecting cash from customers
•
Paying cash to suppliers
•
Selling items for cash
•
Paying expenses
•
Paying employees
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
111
The nature of cash and cash flows
Main types of cash receipts
and payments
Bo
x
Revenue receipts and payments are cash
receipts and payments arising from the
normal course of business.
Capital receipts are receipts of long-term
funds or cash from the sale of non-current
assets or long-term investments. The owners
of a business put new capital into the
business in the form of new cash.
AC
C
A
G
lo
ba
l
The ‘dynamics’ or patterns of revenue
receipts and payments varies greatly
between different types of business. Many
businesses have regular expenditure
patterns, such as constant monthly salary
costs and regular monthly accommodation
costs. However, patterns of cash receipts
vary enormously between different types of
business.
Capital payments are payments for capital
expenditure, such as the purchase of new
non-current assets (equipment, motor
vehicles and so on).
Drawings/dividends
When a business makes profits, it usually
pays out some of those profits to its owners.
•
112
Payments out of profits to a sole trader
or partners in a partnership are known as
drawings.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 16
Payments out of profits to the
shareholders of a company are known
as dividends.
Businesses can pay drawings or dividends
whenever they want to.
Exceptional receipts and payments
In the short term, profits and cash flow are
different. There are several reasons for this.
•
Some items of cash spending and cash
receipt do not affect profits at all such as
capital payments or receipts.
•
Some accounting adjustments (such as
depreciation, prepayments and accruals)
affect profits but do not affect cash at all.
AC
C
A
G
lo
ba
l
An unusual or ‘exceptional’ transaction
that does not fall into any of the categories
described above. It is usually an unexpected
event. An example would be the costs of
closing down part of a business.
Cash flow and profit
Bo
x
•
KAPLAN PUBLISHING
•
Investing in working capital affects cash
flow, and when the total amount of
working capital of a business changes,
the profits earned in the period will differ
from the operational cash flows. This
is down to timing issues. For example,
a business has to pay for its inventory
before it earns anything from sales. Or
when businesses sell goods or services
on credit, they make a profit when the
sale occurs, but they do not get any cash
receipts until the customer pays.
www.ACCAGlobalBox.com
113
The nature of cash and cash flows
•
To survive in the short term a business
must have liquidity. Liquidity means cash
or ready access to sources of cash, such
as new borrowing.
A business that has reached its
borrowing limits needs to have positive
cash flow to survive.
•
Cash flow management should ensure
survival and promote sustainable growth
in the business.
Accruals accounting
Definition
The accruals concept in accounting has
been defined as follows. ‘Revenues and
costs are accrued (that is, recognised as
they are earned or incurred, not as money
is received or paid), matched with one
another so far as their relationship can be
established or justifiably assumed, and dealt
with in the income statement of the period to
which they relate.’
AC
C
A
G
lo
ba
l
•
Cash accounting and
accruals accounting
Bo
x
Liquidity
Accruals accounting is recognised by law,
and businesses are required to use it to
measure their profitability for the purpose of
external financial reporting.
Accruals – it may be that an expense has
been incurred within an accounting period,
for which an invoice may or may not have
114
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 16
It is an accounting method where receipts
are recorded during the period they are
received, and the expenses in the period in
which they are actually paid.
Prepayment – it may be that an expense
has been incurred within an accounting
period that related to future period(s). The
proportion of the charges that relate to future
periods (a prepayment) must be calculated
and included as an adjustment in the
accounts for that period.
However, cash accounting is not generally
accepted as good accounting practice.
Definition
G
lo
ba
l
AC
C
A
Cash accounting
Bo
x
been received. An estimate of the cost (an
accrual) must be made and included as an
accounting adjustment in the accounts for
that period.
Cash accounting is an alternative to
accruals accounting. It is a system of
accounting for costs and income on the basis
of cash payments and cash receipts.
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
115
AC
C
A
G
lo
ba
l
Bo
x
The nature of cash and cash flows
116
www.ACCAGlobalBox.com
KAPLAN
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
17
G
lo
ba
l
Cash management,
investing and finance
In this chapter
Treasury management.
AC
C
A
•
•
Procedures, authorisation and security.
•
Surplus funds.
•
Types of investment.
•
Marketable securities.
•
Cash deficits.
•
Financing.
•
External influences on cash balances.
www.ACCAGlobalBox.com
117
Cash management, investing and finance
of acquisitions and divestments, dividend
policy and defence from takeover.
Treasury management
Roles
cash and currency management
(including foreign currency)
•
investment in short-term assets
•
raising finance.
•
Size and internationalisation of
companies. These factors add to both
the scale and the complexity of the
treasury functions.
Bo
x
•
•
Size and internationalisation of currency,
debt and security markets. These
make the operations of raising finance,
handling transactions in multiple
currencies and investing much more
complex. They also present opportunities
for greater gains.
•
Sophistication of business practice. This
process has been aided by modern
communications, and as a result the
treasurer is expected to take advantage
of opportunities for making profits or
minimising costs, which did not exist a
few years ago.
G
lo
ba
l
banking and exchange
Responsibilities
118
Why?
•
report to the finance director (financial
manager), with a specific emphasis
on borrowing and cash and currency
management
•
have a direct input into the finance
director’s management of debt capacity,
debt and equity structure, resource
allocation, equity strategy and currency
strategy
•
be involved in investment appraisal, and
the finance director will often consult the
treasurer in matters relating to the review
AC
C
A
•
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 17
Procedures, authorisation
and security
Legal restrictions on Local Authorities
•
Section 43 of the Local Government and
Housing Act 1989 empowers councils to
borrow money.
•
Under Section 111 of the Local
Government Act 1972, local authorities
also have the power to lend surplus
funds to facilitate the discharge of their
functions.
G
lo
ba
l
A treasurer should be given a limit to the
total amount he or she can invest without
approval by senior management, and to
the amount that he or she can invest in a
particular form of security.
Bo
x
Authorisation limits for investing
AC
C
A
If the cash available for investment goes
above an individual’s authorised limit, he or
she must notify the appropriate person (e.g.
a supervisor) and ask for instructions.
•
The Local Government Act 2003, and
subsequent regulations, introduced a
new ‘prudential’ framework that governs
the capital financing and treasury
management arrangements of local
authorities.
•
The implicit policy objective of the current
regime is to encourage authorities to
place their funds in forms of deposit
that are relatively safe and quickly
accessible.
•
The regulations do not prohibit any forms
of investment.
Investment guidelines
•
It is good practice to have guidelines for
investing surpluses.
•
It is very common in the public sector
(due to increased public scrutiny).
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
119
Cash management, investing and finance
•
120
UK clearing banks and wholly owned
subsidiaries where the repayment
is guaranteed by a parent bank with
the appropriate ratings
Cash handling procedures
There are four critical areas for ensuring that
cash, cheques, credit and debit card receipts
are safeguarded against loss or theft:
G
lo
ba
l
–
from the Office of the Deputy Prime
Minister (ODPM), the annual Treasury
Management and Investment Strategy
has to be approved by the full Council.
Bo
x
However, non-approved investments
must be charged in-year when made
and, when realised, up to 75% of the
proceeds have to be set aside as
provision for credit liabilities (PCL). This
is a powerful incentive to use only the
listed options, which are:
–
building societies
–
non-UK deposit taking banks
–
local authorities
–
gilts
–
Euro-Sterling bonds permitted by the
Regulations
–
Public Works Loans Board/
Government.
AC
C
A
•
In accordance with the Code of Practice
for Treasury Management in the
Public Services and recent guidance
Accountability – this requires the person to
have the authority to carry out the task.
Segregation of duties – staff duties should
be developed so that cash receipt and initial
recording is assigned to one individual and
reconciling duties are assigned to another.
Functions that need to be separated include:
•
record keeping – creating and
maintaining department records
•
authorisation – review and approval of
transactions
•
asset custody – access to and/or control
of physical assets, i.e. cash, cheques
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 17
reconciliation – assurance that
transactions are properly recorded.
Physical security is assurance that the
safety of people and assets (specifically
cash) is maintained and controlled.
Surplus funds comprise liquid balances held
by a business, which are neither needed to
finance current business operations nor held
permanently for short-term investment.
How surplus funds may arise
•
unexpectedly large amounts of cash that
have been generated from operations;
this could be higher income from sales
due to an increase in sales revenue
AC
C
A
G
lo
ba
l
Reconciliation requires assurance that
transactions are properly documented and
approved and competent and knowledgeable
individuals are involved. A reconciliation
is performed to verify the processing and
recording of transactions.
Surplus funds
Bo
x
•
KAPLAN PUBLISHING
•
lower costs maybe because of improved
productivity or a cost-cutting exercise
•
improvements in working capital
management
•
sales of non-current assets
•
seasonal factors – surpluses generated
in good months are used to cover
shortfalls later.
www.ACCAGlobalBox.com
121
Cash management, investing and finance
Investing surpluses
if a cash surplus is expected to be
temporary, the business should use the
surplus to obtain additional income, but
without exposing itself to unacceptable
risk of losses.
Loan stocks and equities
•
Loan stocks are issued by governments
(UK and foreign) and companies.
Maturities, risks and returns vary.
•
Equities are probably the riskiest shortterm investment opportunities for the
following reasons:
AC
C
A
G
lo
ba
l
•
Types of investment
if a cash surplus is expected to be
permanent, this means that it has no use
for the cash and so there is no reason to
keep it. The most appropriate decision is
probably to pay the money back to the
business owners
Bo
x
•
Dividends are not mandatory.
–
The capital value of the equities can
vary wildly.
–
There is also no guarantee with
equities that all of the capital will be
returned.
Retail bank and building society accounts
A deposit account is an account for holding
cash for a longer term.
•
122
–
Instant access accounts allow instant
access to your cash.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 17
•
High interest accounts are preferable
when larger sums are available to invest
(minimum $500). These usually give
instant access to funds as well as a
higher rate of interest.
•
Specialist bonds – all with different
objectives – for those with at least
$5,000 to invest.
Bo
x
Notice accounts, where savings earn a
better rate of interest if you agree to lock
them away for some time.
G
lo
ba
l
•
Other types of investment with banks
Money market deposits offer real
flexibility for larger amounts of money.
For example, with $50,000 or more,
fixed-term, fixed-rate deposits can be
arranged for periods from overnight to
five years.
•
Option deposits are arrangements for
predetermined periods of investment,
ranging from two to seven years. Interest
rates are generally linked to base rates,
giving a guaranteed return in real terms
but restricted access to funds is the price
paid for higher guaranteed interest rates.
KAPLAN PUBLISHING
AC
C
A
•
www.ACCAGlobalBox.com
123
Cash management, investing and finance
An investor in bills needs to consider the
risks and returns involved. There are two
risks for an investor in bills.
Credit risk. This is the risk that the bill
will not be paid at maturity.
•
The risk of a change in interest rates.
This risk does not exist for any investor
who buys a bill and then holds it to
maturity. Interest rate risk only exists for
investors who buy bills with the intention
of re-selling them before maturity. The
risk arises because if market rates
of interest go up, the market value of
bills will fall. (Equally, if market rates of
interest fall, the market value of bills will
rise.)
Advantages
Disadvantages
Can be sold at any
time
Penalty charges for
early repayment
G
lo
ba
l
•
rate. A CD is negotiable, which means that it
can be sold by its original holder to another
investor at any time before the end of the
deposit period.
Bo
x
Marketable securities
Higher interest
rate than deposit
accounts
Value changes until
repayment
AC
C
A
Low risk
Certificates of Deposit
A Certificate of Deposit (CD) is a financial
instrument issued by a bank, certifying
that the holder has the right to a fixed-term
deposit of funds earning a specified interest
124
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 17
These are marketable British Government
securities. Gilts usually have fixed interest
rates, although there are also various indexlinked gilts.
Redemption yield. Redemption yield
is the interest yield plus or minus an
amount to reflect the difference between
the market price of the gilt and its
eventual redemption value.
Bo
x
•
Gilt-edged securities (Gilts)
Local Authority stock
Disadvantages
Very low risk
Value changes until
repayment
Available in small
and large amounts
Governments may
default
AC
C
A
Easy to sell
Gilt yields are measured and reported in
three ways.
•
•
Local authority stock is issued by local
government authorities (‘local councils’) with
the ultimate backing of the government.
Local authority bonds pay a fixed coupon
rate of interest, and interest is paid every six
months.
G
lo
ba
l
Advantages
Coupon yield. The coupon yield is the
fixed rate of interest, expressed as a
percentage of nominal value.
Advantages
Disadvantages
Slightly better
returns than gilt
Less liquid than gilts
Slightly more risky
than gilts
Interest yield. The interest yield on gilts is
the annual interest receivable, expressed
as a percentage of the market price.
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
125
Cash deficits
Financing
A cash deficit arises when there is an excess
of expenditures over revenues during a
certain period due to
Bank loans
•
Poor trading performance
•
Poor control
•
Poor planning
Bo
x
Cash management, investing and finance
•
Poor working capital management
•
Unexpected expenditure.
G
lo
ba
l
Loan type
AC
C
A
126
Bank loans are a very flexible form of
finance. There are twelve common types of
loans:
Explanation
Short-term
loans
Credit that is usually paid
back in one year or less.
Intermediateterm (IT) loans
Credit extended for
several years, usually
one to five years.
Long-term
loans
Loans for which
repayment exceeds five
to seven years and may
extend to 40 years.
Unsecured
loans
Credit given out by
lenders on no other basis
than a promise by the
borrower to repay.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 17
Instalment
loans
Loans in which the
borrower or credit
customer repays a set
amount each period until
the borrowed amount is
cleared.
Simple interest
loans
Loans in which interest is
paid on the unpaid loan
balance.
AC
C
A
Add-on interest Credit in which the
loans.
borrower pays interest
on the full amount of
the loan for the entire
loan period. Interest is
charged on the face
amount of the loan at the
time it is made and then
‘added on’.
KAPLAN PUBLISHING
Discount or
front-end loans
Loans in which the
interest is calculated and
then subtracted from the
principal in advance.
Bullet loans
Loans in which the
borrower pays no
principal until the amount
is due.
Bo
x
Loans that involve a
pledge of some or all of a
business’s assets.
G
lo
ba
l
Secured loans
Balloon loans
Loans that normally
require only interest
payments each period,
until the final payment,
when all principal is due
at once.
Amortised
loans
A partial payment plan
where part of the loan
principal and interest on
the unpaid principal are
repaid each year.
www.ACCAGlobalBox.com
127
Cash management, investing and finance
There are two types:
•
Committed – the bank agrees to allow
the customer to be overdrawn up to
the agreed limit, at any time during an
agreed period of time.
AC
C
A
•
Uncommitted – the bank agrees to allow
the customer to be overdrawn up to an
agreed limit, but reserves the right to
reduce the overdraft limit, or withdraw
the overdraft facility completely, at any
time and without notice
A committed facility is more expensive
to arrange, but an uncommitted facility
exposes a business to the risk that the bank
128
Loan terms and conditions
Every agreement should specify:
•
the term of the agreement
•
the amount of the loan (the ‘loan
principal’) or overdraft limit
G
lo
ba
l
Interest on an overdraft is usually charged at
a daily rate on the overdraft balance, and the
rate is variable (usually subject to change
whenever the bank alters its base rate).
Overdrafts are repayable on demand. Unlike
for private individuals, businesses pay an
arrangement fee on an overdraft.
can demand repayment at any time, and
effectively make the business insolvent.
Bo
x
Overdrafts
•
the interest rate payable, which is usually
a variable rate and expressed as a
margin above base rate or LIBOR
•
the frequency of interest payments.
Charges on assets
Fixed charge
•
security in the form of a specified asset
•
on default, the lender can take the
secured asset
•
the borrower cannot sell off the secured
asset until the loan is repaid.
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 17
•
security in the form of assets such as its
inventory and receivables
•
the borrower can continue to trade in
these assets
on default, the floating charge will
‘crystallise’, and the bank will acquire the
rights over the categories of assets that
are subject to the floating charge that the
business owns at that time.
A bank might also ask for a personal
guarantee from the business owner.
•
Economic cycles.
•
Inflation and exchange rates.
•
There may also be trends in the financial
environment (e.g. a ‘credit crunch’).
•
Government policies or incentives.
G
lo
ba
l
•
External influences on cash
balances
Bo
x
Floating charge
•
Interest rates.
•
Markets trends.
AC
C
A
A loan or overdraft agreement will also have
other terms and conditions called covenants.
Most of these relate to undertakings given
by the borrower to the bank. If the borrower
breaches any of the covenants on a loan,
he will be in default, and the bank will have
a right to call in the loan and exercise any
security that it has.
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
129
AC
C
A
G
lo
ba
l
Bo
x
Cash management, investing and finance
130
www.ACCAGlobalBox.com
KAPLAN
Downloaded From "http://www.ACCAGlobalBox.com"
18
G
lo
ba
l
Cash budgets
Bo
x
chapter
In this chapter
Objectives of a cash budget.
•
Cash forecasting.
•
Forecasting with inflation.
•
Cash budgets as a mechanism for monitoring and
control.
AC
C
A
•
www.ACCAGlobalBox.com
131
Cash budgets
Objectives of a cash budget
Estimating future cash flows
Reasons for preparing a cash budget
Time series analysis examines past data to
establish two elements from the data:
132
To help to identify weaknesses in cash
management, such as inadequate
procedures for collecting money from
receivables.
•
an underlying trend (or pattern) in cash
receipts or payments (for example it
might be found to be increasing month
on month or year on year)
Bo
x
•
To estimate or plan future cash
shortages/surpluses and allow time to
make plans for dealing with them.
•
seasonal variations in the data that
identify peaks and troughs in year.
G
lo
ba
l
•
To set borrowing limits and minimise cost
of funds.
•
To maximise interest earnings.
•
To provide an early warning of liquidity
problems.
•
For foreign exchange risk management.
•
For budgeting for capital expenditure and
project appraisal.
AC
C
A
•
These elements can then be used to forecast
future sales. This is likely to have a knock on
impact on other data in our forecasts such as
purchases and maybe even wage payments
(if, for example, extra staff are hired during
peak periods).
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 18
Cash forecasting
To prepare a cash budget, assumptions
have to be made about:
when customers will pay
•
the level of bad (irrecoverable) debts.
Payments
G
lo
ba
l
•
Bo
x
Receipts from sales
In determining payments assumptions must
be made on:
purchases/expenses in each time period,
analysed between credit purchases and
(if any) cash purchases
•
estimates for the amount of credit taken
from suppliers (for example, one month
or two months).
KAPLAN PUBLISHING
AC
C
A
•
www.ACCAGlobalBox.com
133
Cash budgets
Index numbers
•
forecasts can become out of date very
quickly.
•
the value of financial assets (e.g.
receivables) declines
•
interest rates may be higher.
G
lo
ba
l
Most accountants acknowledge that the
accounts of businesses are distorted when
no allowance is made for the effects of
inflation. The use of index numbers is often
required for the preparation of inflationadjusted accounts.
The impact of inflation on cash flow and
profits
Bo
x
Forecasting with inflation
AC
C
A
An index number shows the rate of change
of a variable from one specified time to
another. A price index measures the change
in the money value of a group of items
over a period of time. Inflation is usually
measured as a percentage increase in the
RPI.
134
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 18
Cash budgets as a
mechanism for monitoring
and control
Monitoring actual cash flows
Consulting staff about future cash flows
•
•
Bo
x
•
predicting what cash flows are now likely
to be in the future, and in particular
whether the business will have enough
cash (or liquidity) to survive
that they agree with the assumptions
in the cash budget about income and
expenditure, and receipts and payments
whether there are any other exceptional
items of receipt or payment that have
been overlooked and so are missing
from the draft cash budget.
•
the reasons for any significant
differences between actual and budgeted
cash flows.
AC
C
A
•
identifying whether cash flows are much
better or worse than expected
G
lo
ba
l
When a cash budget is drafted, appropriate
individuals (operational managers) should be
consulted, to check:
Comparing actual cash flows with the budget
can help with:
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
135
Cash budgets
Regular reporting of actual budgeted cash
flows compared with budgeted cash flows
should be carried out on a daily, weekly or
monthly basis, depending on the size of the
business and the frequency and value of its
cash receipts and payments.
Bo
x
Cash flow control reports
AC
C
A
G
lo
ba
l
The reasons for any differences should be
investigated and corrective action taken
when necessary.
136
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
19
G
lo
ba
l
Information for Comparison
In this chapter
Making comparisons.
•
Common comparisons.
•
Using flexed budgets.
•
Exception reporting.
•
Cost variances.
•
Cost variances – materials.
•
Cost variances – labour.
•
Revenue variances.
•
Causes of variances.
•
Investigating variances.
AC
C
A
•
www.ACCAGlobalBox.com
137
Information for comparison
Making comparisons
Assess performance
•
Reward managers
•
Control processes/departments
•
Make decisions
Common comparisons
G
lo
ba
l
•
Bo
x
Why
Previous periods
to identify trends
AC
C
A
Corresponding
periods
same months each
year to remove any
seasonal fluctuations
Forecast data
usin feedforward
control
Comparisons
frequently used
Budget data
identify differences
in activity levels
Standard costs
for variance analysis
138
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 19
Using flexed budgets
When comparing expenses against standard costs, the original (fixed budget) needs to be adjusted
to the actual level of activity before variances are determined.
Bo
x
Example
Only ‘flex’
variable costs
Activity level (units)
Original
Budget
Flexed
Budget
Actual
results
20,000
40,000
40,000
AC
C
A
Costs
G
lo
ba
l
A company had originally planned to produce 20,000 units but actually produced 40,000 units:
Variances
F/A
Variable labour
$100,000
$200,000
$180,000
$20,000 F
Fixed labour
$40,000
$40,000
$42,000
$42,000 A
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
Compare only
flexed and actual
Use the same
units as the
actual results
139
Information for comparison
Exception reporting
Benefits of exception reporting
140
G
lo
ba
l
Exception reporting: principle of highlighting
for management attention only variances
which exceed certain limit (percentage or
absolute amount).
Bo
x
Definition
Management focuses on important
variances only.
•
Limits amount of information provided to
management – and management’s time
in reviewing.
•
Favourable variances investigated
as well as unfavourable. Favourable
variances may be ‘bad’ e.g. favourable
wages variance may indicate labour
shortage.
AC
C
A
•
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 19
Cost variances
Changes in
volume of capacity
Reasons for
cost variances
Bo
x
Changes in prices paid for/efficiency with
which resources used
Activity (volume) cost variance
$
x
(x)
x
Ori inal bud eted direct cost
Flexed direct cost bud et
Activity (volume) cost variance
AC
C
A
Total direct cost variance
$
Ori inal bud eted direct cost x
(x)
Actual direct cost incurred
Total direct cost variance
x
G
lo
ba
l
Calculation of cost variances
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
Variance due to other changes
$
Flexed direct cost bud et x
Actual direct cost incurred (x)
Total direct cost variance
x
141
Information for comparison
Cost variances – materials
Example
Budgeted material cost per unit =
$12,000/3,000 = $4 per unit
Actual production = 2,800 units, actual
material cost = $11,890 for 2,900 kg
purchased
Flexed materials budget = 2,800 kg × $4 =
$11,200
G
lo
ba
l
Bo
x
Materials budget for period = $12,000 for
production of 3,000 units
Materials cost variances
Total materials cost variance
$
12,000
(11,890)
110 F
AC
C
A
Ori inal bud eted material cost
Actual material cost incurred
Total materials cost variance
Materials variance due to other changes
$
11,200
(11,890)
690 A
Flexed material cost bud et
Actual material cost incurred
Materials cost variance (other)
Materials activity (volume) variance
$
Ori inal bud eted material cost
12,000
(11,200)
Flexed material cost bud et
800 F
Materials activity (volume) cost variance
142
www.ACCAGlobalBox.com
Proof: Total materials cost
variance = Materials activity
(volume) variance + Materials
variance due to other chan es
= 800 F + 690 A = 110 F
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 19
Price variance – reasons for
Usage variance – reasons for
Adverse
Favourable
Adverse
Price increase
More efficient design
Less efficient design
Quantity discount
Discount withdrawn
Decreased wastage
Increased wastage
Lower quality
Higher quality
Better quality material
Lower quality material
AC
C
A
G
lo
ba
l
Bo
x
Favourable
Cheaper supplier
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
143
Information for comparison
Cost variances – labour
Example
The rate paid for hour’s labour = $8
Flexed labour budget = 4,000 units × 1 hour ×
$8 = $32,000
G
lo
ba
l
Actual production = 4,000 units, actual labour
cost = $34,000
Budgeted labour cost per unit =
$33,600/4,200 units = $8 (i.e.one hour per
unit)
Bo
x
Labour budget for period = $33,600 for
production of 4,200 units
Labour cost variances
Total labour cost variance
$
33,600
(34,000)
400 A
AC
C
A
Ori inal bud eted labour cost
Actual labour cost incurred
Total labour cost variance
Labour variance due to other changes
$
Flexed labour cost bud et
32,000
(34,000)
Actual labour cost incurred
2,000 A
Labour cost variance (other)
Labour activity (volume) variance
$
33,600
(32,000)
1,600 F
Ori inal bud eted labour cost
Flexed labour cost bud et
Labour activity (volume) cost variance
144
www.ACCAGlobalBox.com
Proof: Total labour cost
variance = Labour activity
(volume) variance + Labour
variance due to other chan es
= 1600 F + 2,000 A = 400 A
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 19
Favourable
Cheaper grade of
labour used
Adverse
More expensive grade
of labour used
Higher quality
Adverse
Improved working
methods
Worse working
conditions
More skilled labour
used
Less skilled labour
used
New bonus scheme
Poor supervision
AC
C
A
Lower quality
Favourable
G
lo
ba
l
Pay increase less than Pay increase more
budget
than budget
Efficiency variance – reasons for
Bo
x
Rate variance – reasons for
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
145
Information for comparison
Revenue variances
Example
Bo
x
Flexed sales budget = 11,000 × $15 =
$165,000
G
lo
ba
l
A company has budgeted sales of 10,000
units per month at $15.00 per unit. Last
month it actually sold 11,000 units for
$159,500.
Revenue variances
AC
C
A
Total sales variance
$
Ori inal bud eted sales revenue 150,000
(159,000)
Actual sales revenue
Total sales variance
9,500 F
Selling price variance
Flexed sales bud et
Actual sales revenue
Sellin price variance
Sales activity (volume) variance
$
Ori inal bud eted sales revenue 150,000
(165,000)
Flexed sales revenue bud et
15,000 F
Sales activity (volume) variance
146
www.ACCAGlobalBox.com
$
165,000
(159,500)
5,500 A
Proof: Total labour cost
variance = Labour activity
(volume) variance + Labour
variance due to other chan es
= 1600 F + 2,000 A = 400 A
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 19
Causes of variances
Variances are interdependent e.g. purchasing lower cost materials
Adverse usage variance, and
•
Adverse labour variance as workers take longer to use poor materials.
Bo
x
•
G
lo
ba
l
Poor bud etin
Different amounts
of wasta e
eneral reasons
for variances
AC
C
A
Poor recordin of
usa e of materials/
labour
Operational factors
e. . different
rades of labour
Exam focus
In the exam, you may have to calculate a variance or identify reasons for variances occurring.
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
147
Information for comparison
Investigating variances
Bo
x
Is variance controllable?
Investigating variances –
factors to consider
G
lo
ba
l
Possible interrelationships?
AC
C
A
Size of variance
148
www.ACCAGlobalBox.com
Cost of investi ation/
savin s arisin
Trend in variance
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
chapter
Bo
x
20
G
lo
ba
l
Reporting management
information
In this chapter
Reporting.
AC
C
A
•
•
Choice of format.
•
Presentation of data.
•
Choice of presentation method.
www.ACCAGlobalBox.com
149
Reporting management information
Reporting
Report formats used:
Reporting
Communication format depends on:
• Speed
• Whether written report needed
• Level of confidentiality
• Cost
• Distance
• Level of complexity of data
Rules for a good report
Paragraphs
One point
per para raph
150
•
Letter
•
Email
•
Memo
•
Report
REPORT
To: Managing Director
From: Candidate
Date: Dec X3
Subject: Net present value technique
The Net present value technique relies on discounting relevant cashflows at
an appropriate rate of return.
It would be helpful to know:
1. Whether there are any additional cashflows beyond year five.
2. Whether the introduction of a new product will affect sales of the existing
products E, C and R.
On the basis of the information provided, the project has a positive net
present value of $28,600 and should be carried out.
AC
C
A
Heading
Needs to, from, subject
and date
G
lo
ba
l
Maintain appropriate
level of confidentiality
Recipient
May affect report desi n e. .
MD needs summary only
Note
Bo
x
Must be in
house style
•
www.ACCAGlobalBox.com
Jargon
Avoid or explain
where used
Figures
Detailed fi ures can be
included in appendix
Conclusion
Must be clearly stated
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 20
Choice of format
Consider:
Speed and timing
•
Complexity
•
Confidentiality
•
Cost
•
Distance
•
Number of recipients
•
Need for evidence
AC
C
A
G
lo
ba
l
Bo
x
•
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
151
Reporting management information
Presentation of data
Main methods of presenting data:
Table
•
Diagram
Bo
x
•
Choice of medium depends on factors shown on right.
Nature of audience
Normally dia ram
for less technical
audiences – table where
detail needed
AC
C
A
Nature of the data
Dia ram for small
amounts of data –
table for lar e amounts
G
lo
ba
l
Factors to consider
152
Method of delivery
Normally table
in report and dia ram
for presentation
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Chapter 20
Choice of presentation method
Key disadvantage
Bar/column
Can be broken into
components
Totals and accuracy
can be lost
Comparing
components over
time
Pie
Good for assessing
relative importance
May be too simple
Showing relative
size of each
component
Scatter graphs
Can cope with a
wide range of data
Limited to two
variables
Illustrating a random
relationship
Line graphs
Illustrates trends
and seasonality
Complicated if lines
intersect
Identifying trends
Can illustrate both
the total and the
components
Limited to one
overall total
An alternative to
bar charts when the
total is important
Area chart
G
lo
ba
l
Bo
x
Key advantage
AC
C
A
Type
Suitability
Exam focus
Examination questions tend to focus on factual knowledge of reports such as which type of chart to
use in a specific situation.
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
153
AC
C
A
G
lo
ba
l
Bo
x
Reporting management information
154
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Bo
x
Downloaded From "http://www.ACCAGlobalBox.com"
AC
C
A
G
lo
ba
l
Index
www.ACCAGlobalBox.com
I.1
Index
C
Capital expenditure 49
Capital payments 112
Capital receipts 112
Cash 110
Cash accounting 115
Cash cycle 110
Cash deficits 126
Cash flow and profit 113
Cash flow control reports 136
Cash handling procedures 120
Certificates of Deposit 124
Closure of a business segment 94
Continuous stocktakes 30
Contribution 62
Contribution/Sales ratio 84
Cost or revenue centre 7
Cost unit 13
B
Balloon loans 127
Bank loans 126
Break-even charts 88
I.2
AC
C
A
G
lo
ba
l
Abnormal gain 72
Abnormal loss 71
Absorption costing 52
Absorption rate 55
Accountability 120
Accounting for materials costs 27
Accounting for production overheads 58
Accounting treatments
for by-products 76
Accruals accounting 114
Accruals concept 114
Amortised loans 127
Annuity 104
A responsibility centre 6
Authorisation limits for investing 119
Avoidable and unavoidable costs 91
Break-even point 85
Bulk purchase discounts 33
Bullet loans 127
By-product 74
Bo
x
A
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Index
Cost variances 141
Cost-volume-profit (CVP) analysis 84
C/S ratio 84
Expenses 48
External services 80
F
E
Economic order quantity (eoq) 32
Equities 122
Estimating future cash flows 132
Estimating future costs 21
KAPLAN PUBLISHING
FIFO 26
Financing 126
First in first out (FIFO) 24
Fixed charge 128
Fixed costs 18
Floating charge 129
Forecasting with inflation 134
Full factory cost 17
Further processing 77
G
lo
ba
l
AC
C
A
Data 3
Deposit account 122
Depreciation 50
Direct cost 16
Direct expense 48
Direct labour 41
Discounted cash flow 101
Discounted payback method 107
Documentation 12
Documentation of labour time 43
Drawings/dividends 112
Bo
x
D
G
General reasons for variances 147
Gilt-edged securities (Gilts) 125
H
High interest accounts 123
High-low method 22
www.ACCAGlobalBox.com
I.3
Index
J
Identifying relevant costs 95
Idle time ratio 45
Index numbers 134
Indirect costs 16
Indirect expense 48
Indirect labour 41
Inflation 134
Information 3
Integrated accounts 10
Interest 100
Interlocking accounts 10
Internal rate of return method (irr) 105
Internal services 80
Inventory losses and waste 27
Inventory re-order level 34
Investigating variances – factors to consider
148
Investment appraisal 98
Investment guidelines 119
IT 7
Job costing 67
Joint costs 75
Joint products 74
Just-in-time 37
Bo
x
I
L
AC
C
A
G
lo
ba
l
Labour cost variances 144
Labour efficiency 44
Labour turnover 43
Labour utilisation 45
Last in first out (LIFO) 24
Legal restrictions on Local Authorities 119
LIFO 26
Limiting factors 92
Liquidity 114
Loan stocks 122
Loan terms 128
Local Authority stock 125
Local Government Act 2003 119
Losses 71
I.4
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Index
O
Machine hours method 50
Make-or-buy decisions 92
Management information 2
Marginal costing 62
Margin of safety 86
Marketable securities 124
Materials cost variances 142
Maximum and minimum inventory control
levels 35
Money market deposits 123
Monitoring actual cash flows 135
Monitoring and control 135
Objectives of a cash budget 132
Operating cycle 110
Opportunity costs 91
Option deposits 123
Overdrafts 128
Overhead absorption 52, 55
Overhead allocation 52
Overhead apportionment 52
Overtime premium 42
N
AC
C
A
G
lo
ba
l
Bo
x
M
Net present value method (npv) 103
Non-production overheads 59
Normal loss 71
Notice accounts 123
KAPLAN PUBLISHING
P
Payback 99
Payback period 99
Periodic review system 36
Periodic stocktakes 30
Periodic weighted average cost 25
Perpetuity 104
Physical security 121
Prepayment 115
Presentation of data 152
Prime cost 16
www.ACCAGlobalBox.com
I.5
Index
S
G
lo
ba
l
Q
Qualities of useful management information 4
R
AC
C
A
Reconciliation 121
Recording and coding of costs 14
Reducing balance method 50
Relative sales values 75
Relevant cost 90
Retail bank 122
Return on capital employed (ROCE) 7
Revenue expenditure 49
Revenue variances 146
I.6
Secured loans 127
Segregation of duties 120
Semi-variable costs 20
Service costs 80
Sources of cash 111
Sources of data 5
spare capacity 93
Special contract pricing 93
Specialist bonds 123
Specific order costing 66
Stepped-fixed costs 20
Straight-line method 50
Sunk costs 91
Surplus funds 121
Bo
x
Process account 73
Process costing 70
Production overhead account 58
Production/volume ratio 45
Product units method 50
Profit centre 7
Profit/volume graph 88
T
Target profit 87
The budget cycle 2
Time series analysis 132
Time value of money 100
Total production cost 17
www.ACCAGlobalBox.com
KAPLAN PUBLISHING
Downloaded From "http://www.ACCAGlobalBox.com"
Index
Treasury management 118
Two-bin system 36
G
lo
ba
l
Under and over absorption of overheads 56
Unsecured loans 126
Uses of cash 111
Uses of CVP analysis 85
V
AC
C
A
Valuation of normal loss 71
Variable costs 19
W
Bo
x
U
Weighted average cost (AVCO) 25
Weighted average price 26
KAPLAN PUBLISHING
www.ACCAGlobalBox.com
I.7
AC
C
A
G
lo
ba
l
Bo
x
Index
I.8
www.ACCAGlobalBox.com
KAPLAN