ACCOUNTING NOTES

The Accounting Equation

Assets = Owners Equity + Liabilities

Or

Assets - Liabilities = Owners Equity

Sole Trader - liable for all debts incurred, can be sued for the shirt on his backPartnership - two or more people equally liable for the debts of the company Company - Limited in that it has a limited number of share equal to the initial investment of the company (this can be increased as the company grows-see later modules). The shareholders can be sued for the par or face value of the original share not its current value which trades higher or lower dependant on the value placed by the market.

MODULE 2

THE PROFIT AND LOSS ACCOUNT

Profit is the difference between sales and the cost of sales.

Cost of sales include - Direct costs- labour and material (production costs) Indirect costs - support staff, advertising etc

Profit can be measured as the difference between -

Measure of Accomplishment - is measured as the first point in the Operating cycle when the following are satisfied -

1. The principle revenue producing service has been performed (the goods are made and shipped to a firm order.

2. All production cost have been incurred or those that have not are negligible or can be predicted within an n acceptable degree of accuracy.

3. The amount to be received can be predicted within an acceptable degree of error.

This is the shipping and invoicing method of accomplishment. The other 3 are -

1. Time of Sales - salesman sees the sale as time of order. Ice cream vendor. Failings are that the order may be cancelled leaving specially ordered goods unsold.

2. Time of Production - Gold mining. Engineering3. Time of Collection - Cars large electrical equipment

Accounting Conventions dictate how the sales will be recorded in the P&L account -

Realisation Convention - Only sold goods are recognised as Sales

Accruals Convention - Revenues and costs are accrued (recognised as they are earned or incurred) and matched with one another in the Profit and Loss Account for the period to which they relate (rent paid for the year is split between the P&L account for the 2 periods that it covers).

And

Measure of Effort - What Sales have cost. These too are subject of conventions -

Matching Convention - matches costs to the units shipped and invoiced during the accounting period - not the goods produced (this is used later in accounting for managers)

Cost Convention - the cost used is the historical cost I.e. the cost when the inventory or machine was acquired.

Allocation Convention - firstly determine how much of the means of production is used in producing the goods made and then allocated for the accounting period (raw materials labour electricity etc.). Secondly, how much of each means of production should be matched with sales revenue, closing inventory of both unfinished and finished goods.

Determining Means of Production Costs -

1. Labour 2. Depreciation of fixed assets 3. Use of Raw Materials

Labour costs - these can be determined from the payroll

Depreciation costs. There are several ways to calculate depreciation but the there must be regard to the original (historic cost), resale or scrap value and length of useful life.

Method 1 - Straight LineEqual amounts are deducted for depreciation over the life of the machine -

Cost - scrap value / useful life

Method 2 - Reducing BalanceHere large amounts of depreciation are deducted in the first few years when the machine is at its most productive and the costs of maintenance are lower acting as a counterbalance to higher maintenance costs in later life. Finding a % for the annual depreciation charge and deducting that from the balance over the period calculate this.

*Remember to multiply the annual % by the life before inputting it to the calculator*

Method 3 - Consumption Method

Here it is based on the number of hours consumed i.e. the greater the use the greater

the wear and tear and the greater the depreciation should be.

(Annual Running Hours) / Total number of Running Hours) X Total Net Cost (Purchase Price less Residual Value)

Comparison of Methods

1. Depreciation is the allocation of the cost of an asset purchased in 1 period spread over the periods the asset is used.

2. It is a cost of production (but not a use of cash)3. The method used determines the amount of depreciation in each accounting

period4. It does not provide cash for a replacement but the effect is to reduce the loss of

cash as it lowers profit, which in turn lowers the tax demand and dividend demand.

Determining the Value of Closing Work in Progress and Inventories

The costs involved in producing goods plays an important part in how much profit is shown in the P&L account. This is because of the allocation of costs to unfinished and unsold goods - inventories. The more costs allocated to unsold /unfinished goods, the cheaper the cost to produce finished goods will appear and the greater the profit on the P&L account.

Starting Inventory + Purchases - Closing Inventory = Cost of Goods charged in the P&L account

Inventory consists of -

1. Finished Goods - ready for sale2. Work in Progress - where work has started but they are not yet finished3. Raw materials - to be used in the manufacture

The higher the Inventory value, the higher the reported profit.

Inventory Valuation Methods

Once counted is valued either by the Cost or Conseratism convention.

Cost - sum of expenditure either directly or indirectly incurred

Conservatism - if the goods are not sold and a reduced price is to be realised, the sale price less the cost of the sale gives the value for the inventory.

FIFO - oldest units purchase/produced are sold/used first. This means that in times of inflation, the higher costs of the later goods are reflected in the inventory price. This method produces a Higher reported profit. This in turn attracts higher taxes, dividend payments and lowers the ability to replace stock

LIFO - most recently produced units produced /purchased are sold/used first. This

means that lower profits are reported and the cost of replacing stock is is made easier. This attracts lower taxes and dividends and allows stock to be replaced.

Average Method - the average cost of inventory is found by taking the total cost of materials and dividing it by the number of goods purchased to provide the average cost per unit.

Valuation of Work in Progress and Finished Goods

Product Costs - Raw materials, labour and factory overheads are allocated to the Cost of sales, which is included in the P&L account, and Closing inventory, which is incluede in the Balance Sheet.Period Costs - Selling Administration and Finacial costs (costs not incurred directly in the manufacture but are required to sell the product) are included in the P&L account.

The more a company includes product costs in the valuation of inventory, the higher the valuation and the higher the reported profit.

Interpreting Profit

Gross Profit- Sales less Cost of sales measures efficiency of the transformation process.

Net Profit before Taxes and Interest - Gross profit less Product costs measures overall managerial efficiency.

Net Profit after Interest - measures the financial efficieny of the company

Net Profit after taxes and interest - tells very little.

Summary

The Profit and Loss account or Income statement therefore measures the Sales less the Cost of Sales.

MODULE 3

THE BALANCE SHEET

The Balance sheet gives a view of the worth of a company on specific date, normally the end of the financial year. The balance sheet consists of Assets, fixed and current fewer liabilities.

Fixed Assets - are things that are used in the production not for production - land machinery buildings.

Depreciation is the allocation of the outlay for the asset, operating and is deducted from the Balance Sheet over the life of the asset. Expenses for maintaining the asset are deducted from the profit in the P&L as account.

Land - costs of preparation of the land should be capitalised and added to the value in the Balance sheet.

Fixed assets not owned by the company-

Operating Lease- ownership remains with the finance company. The leased item does not have to appear, as an asset not does the payments have to appear as a liability, though these cost are charged to the P&L account.Finance Lease - Where ownership reverts to the company after the lease term the value is shown in the Balance sheet and the future payments appear as a liability under creditors.

Advantages are - Avoids large outflow of cash for purchase Spreads cash flow over a period Replacement of the asset without sale and purchase Maintenance cost are normally covered in the lease Payments are charged to the P&L account and therefore deductible before tax is

incurred

Current Assets - are those assets that are expected to be used or consumed within 1 year.

Inventories - Valued at lower of cost or market value. Cost is direct manufacturing cost plus a share of factory overheads, excluding

period costs. Valuation effects level of profit.

Debtors - A provision is made for bad debt in the P&L account based on Risks attached to each customer Severity with which non payment will be pursued General economic environment

Any actual bad debt is taken from the P&L account. The provision is increased each year by an agreed amount and this is also taken from the profit in the P&L account.

Current Liabilities - are those debts that require to be paid in 1 year such as creditors, overdrafts taxes payable and dividends payable, also accruals and deferred revenue (prepayments for goods).

Net Current Assets and Net Assets

Net current assets (Liabilities) = Current assets - Current liabilities and gives the ability of the company to meet liquid commitments from liquid resources.

Financing Net Assets - assets are acquired from internally generated funds (profit) or external funds (loans), which can be secured. Secured loans have a right to payment before any payment to shareholders.

The ling between the owners’ equity and loans is called gearing. This is calculated -

Long Term Debt / Total Assets

The % for the long-term debt allows the annual debt to be calculated. This is then subtracted from the annual profit (loss) to give that amount available for equity. The return on equity can be calculated by dividing the profit before interest by the original equity invested by the owner (not debt).

The higher the gearing (higher amount of total equity is by loan), the higher the amounts for equity payments will be when profits are high. When profits are low, highly geared companies have a lower return as more money is paid in interest.

MODULE 4

THE CASH FLOW STATEMENT

The Cash Flow Statement reflects only those economic events that affect cash flows. Cash = cash balances, short-term stocks / investments.

The importance of cash is - 1. Is there sufficient cash to pay dividends2. Is the cash used from dividends from profits or borrowings3. Where did the money for asset purchase come from profits or borrowings4. Is the company solvent - sufficient funds to meet short term obligations5. Is the company borrowing when there is a sufficiency of cash profits

Sources of Cash

1. Profit from Operations - this does not include depreciation which is added back in the Cash Flow statement. Equally it does not include provision for bad debt. This is recorded as a charge against profits in the P&L account.

2. Capital Introduction 3. Increase in Creditors 4. Sale of Fixed Assets 5. Loans6. Decrease in Inventories - this releases cash tied up in inventories7. Decrease in debtors

Uses of Cash

1. Loss from Operations - if after adjustments for depreciation bad debt and sale of assets is made in the P&L account the figure is still negative then there is deemed to be a cash loss consumed by operations

2. Capital Repayments - purchase of own shares this increases ownership and reduces the amount of dividends to be paid.

3. Decrease in Creditors4. Purchase of Fixed Assets5. Repayment of Loans6. Increase in Inventories7. Increase in Debtors

Eight Major Categories of Cash Flow

The flow of cash is recorded in the Cash Flow statement under the following 8 headings -

1. Cash Flow from Operating Activities - the primary source of cash. If you do not produce cash from operations in the long term, the business will be run on borrowed money that will have to be repaid. This category includes increases and decreases from inventories, debtors and creditors and is called ‘working capital’.

2. Cash Flow from Returns on Investments and Servicing of Finance - this reflects the returns from investments in other entities and cash paid out in dividends to non-equity shareholders; minority interest paid on borrowed money.

3. Taxation - this normally relates to the agreed tax to be paid from the previous Fiscal year.

4. Capital Investment - receipts fro the sale or purchase of plant5. Acquisitions and Disposals - cash flows from the purchase or sale of subsidiaries

and joint ventures6. Equity Dividends paid to Shareholders7. Management of Liquid Resources - current asset investments such as short term

bonds that can be realised quickly without upsetting the business8. Financing - this includes cash flow movements in debt (except the overdraft) and

the receipt and payment of shareholders funds

MODULE 5

THE FRAMEWORK FOR FINANCIAL ACCOUNTING

Disclosure - protects investors (creditors and share holders) in Limited companies from unscrupulous traders in that it requires that certain information be reported in a certain manner at ceratin times of the year. A limited company is liable for the amount of the initial investment at the par value of each share.A sole trader is liable for everything to the shirt on his back and the tools of his trade. Companies do not want to disclose for fear of providing competitors and predators with useful information and for fear of interference from out with.

Sources of Disclosure -

The Companies Act 1985 and 1989That the companies P&L account will give a true and fair view of the profit and loss for the year, and the financial state of the company (ie that the fiancial statements have been drawn up in accordance with Accounting Standards).

Accounting Standards This sets out the methods that must be adopted in compiling a companies accounts - ie methods of recording stock LIFO or FIFO, and, any change in the recording method must be explained and a comparison of the change given.

The Stock Exchange List Agreement Any listed company must publish - Half yearly profit reports Directors interest in subsidiaries contracts/ dividends waived Reasons for departures from accounting standards Holdings of more than 20% in opther companies Geographical breakdown of profit

Group Accounts -Holding company owns more than 50% of the subsidiary and must produce consolidated or group P&L and Balance sheet along with its own balance sheet.

The balance sheet will show minority interest being the shareholding left in the

merged company not owned by the parent company. This is then deducte from the consolidated P&L account for the group.

Accounting Policies True and fair view - financial statements and how they are made up should be

representative External auditors - must approve the accounts and how the information is arrived

at. Consistency - once the selection has been made of making up the accounts it must

be consistently applied from year to year.

Balance Sheet

Called up Share capital - companies have a limit on the amount of shares they can issue. These are not always sold and the company can issue these shares up to the its authorised limit, when this limit is reached, the company petitions the court for an increase.

Share Premium Account - this is the difference between the nominal price and the value achieved when the extra shares are sold.

Revaluations - some fixed assets are revalued during their lifetime and this has to be entered in the notes for the Balance sheet.

Fundamental Accounting Concepts

1. Going Concern - that the company will continue to trade for the foreseeable future.

2. Accruals Concept - revenue is recognised when the sale is made by shipping and invoicing and all costs can be anticipated within a reasonable amount.

3. Consistency Concept - no change from year to year without a very good reason4. Prudence Concept - revenue is not recognised until all effort has been expended

(in production) and the customer is likely to pay; that any losses are recognised immediately.

The External Auditor

1. Appointed by the shareholders they are responsible for examining the companies’ accounts and methods for gathering financial information and ensuring that there is no fraud or malpractice.

2. The auditors check the system of bookkeeping, internal controls and accounting practices to ensure that that it is appropriate for the business.

3. Comparisons are made of the accounts with the figure used for their compilation.4. Assets have to be verified along with proof of ownership or title.5. Liabilities are verified with invoices6. Verify that the results in the P&L account are fairly stated7. Confirm that the statutory requirements have been complied with.

MODULE 6

INTERPRETATION OF FINANCIAL STATEMENTS

Ratio Analysis allows the following -1. Comparison of performance between this period and the last2. Comparison between the company and competitors3. Comparison between actual performance and expected4. Detect areas of managerial weakness.

Liquidity Ratios - are designed to measure the companies’ ability to meet its, maturing short-term obligations and ensuring the short run survival of the company.

The ratios are

Current ratio - Current Assets / Current Liabilities. This tells us the ability of the company to meet its short-term debts. A ratio of 2 is considered to be good however; stock may not have a marketable value and give a false picture.

Quick Ratio (or Acid Test) - Current Assets- Inventory / Current Liabilities. This accepts that the inventory may not move quickly or be realised at the valued price. The acceptable ratio is 1 i.e., the company will have enough current assets to meet its obligations.

Profitability Ratios - are designed to measure managements overall effectiveness and gives an insight into long-term survival. Profitability is the measure of the managerial decisions.

Gross Profit Margin - Gross Profit / SalesThis is the first critical measure of profit, before anything is taken away. Gross Profit is Sales less Cost of sales and measures efficiency of the transformation process.

Profit Margin - Profit before Interest and taxes / SalesTaxes are historic (earned the previous year) Net Profit before Taxes and Interest is Gross profit less Product costs measures overall managerial efficiency. Net Profit after Interest measures the financial efficiency of the company.

Return on Total Assets - Profit before Interest and taxes / Total AssetsThis is an indicator as to how the company employs its assets in generating profit.

Return on Specific Assets - Profit before Interest and taxes / The Specific AssetThis allows a return on the specific asset to be measure if it is considered a critical in the management of the company. In the example, if the Quick Ratio indicates that too much inventory is being held, this can be used as the denominator to return ratio.

Return on Capital Employed - Profit before Interest and taxes / Capital employed, this is the total assets of the company less the current liabilities or the owners equity plus the long-term loans. This gives an indication of amount of resources locked into the business and providing a return for the shareholders and loan providers.

Return on Owners Equity - Profit Attributable to Shareholders / Owners Equity. This figure gives the return for investment to shareholders.

Capital Structure Ratios - these are split into two groups, those that measure the asset structure of the company (measure of fixed to current assets), and, those that measure the financing of the company i.e. debt.

Fixed to Current Asset Ratio - Fixed Assets / Current Assets. This indicates value of fixed assets compare to $1 of current assets.

Debt Ratio - Total Debt / Total Assets. The resultant answer is how much of each $1 the invested in the company is in fact from borrowing - debt. If the company is highly geared i.e. has a lot of debt, in times of poor profits, the debtor have first call on the profit before dividends are paid to shareholders. The gearing that gives the return on equity is found = Profits before interest - Interest Charge (=amount available to equity) / Equity.If the owners equity is high then this figure is low and the return on the amount invested is lower than if the owners equity is low and the company has a higher gearing (more debt).

Times Earned Interest - Profit before taxes + Interest Charges / Interest Charges. This figure gives the amount that profit can decline before the company cannot meet its interest payments.

Efficiency Ratios - or activity or turnover ratios measure how efficiently the company manages its assets. It involves the comparison between sales figures and the various assets and assumes that mangers keep a sensible balance between sales and such items.

Inventory Turnover - Sales / Inventory. The figure is then divide into 12 to give how long in months the company keeps inventory and can be compared to its competitors. This is a historic figure given on the year end figure of inventory and must be checked in management terms against the year to see if it is the common length for keeping stock. Inventory can act as a buffer for a sudden demand and it may be cyclical that this occurs at the year end/beginning of next and this is the reason if the figure is high. Equally ’just in time’ inventory and the rapidly changing market for electronic goods makes large inventory a danger for some companies.

Average Collection Period - days sales outstanding. Debtors/Sales per day. This tells us the length of time the company waits for debtors to pay for goods. Remember, debtors are being financed by you!

Fixed Assets Turnover - Sales / Fixed Assets. This relates the investment in fixed assets to the sales generated therefrom.

The Dupont Chart

This chart provides the Return on Total Assets or ROTA. It is achieved thus

Inventories + Debtors + Investments + Cash + Fixed Assets = Total Assets are divided by Sales to give Total Asset Turnover.

Cost of Sales + Distribution Costs + R&D + Administration Costs = Operating Costs are then subtracted from Sales to give Trading Profit which is divided by Sales to give Return.

Total asset Turnover and Return are multiplied to give the ROTA.

100% Statement

Sales are treated as 100. All cost of sales are then turned to a percentage of this figure as is the Trading profit (Sales less cost of sales). This provides a percentage indicator for any increase or decrease in each of the costs over the corresponding period.

Basic Stock Market Ratios

Earnings Per Share Ratio (EPS) - Net Profit / Number of Ordinary Share issued.

Price Earnings Per Share (PE) - Market Price / EPS. This figure represents the purchase of the number of years profit to achieve it. It could be taken as an indicator of whether or not to invest in the company.

Dividend Yield - Dividend per Share / Market Value per Share. This tells the investor what the return is on the share based on the market value of the share not the ordinary share price. As tax is paid before the dividend is paid, companies add the tax paid onto the Dividend figure before dividing it. These figures allow investors to compare companies to see who give the best return on their shares.

Dividend Cover - Net Profit for the year / Dividend Payout. This figure allows an investor to see if profits are being paid from profit or from reserves.

MODULE 7

EMERGING ISSUES AND MANAGERIAL OPTIONS IN FINANCIAL REPORTING

Managers are under pressure to increase profits and growth for the company. This will increase the value of shares and the desire for people to invest and the company to grow and so on. Analysts advise investors where to put their monies and they rely on predictions for profits at the end of each reporting cycle. If the management meets the predicted profit, share price will stay the same as it went to at the time the prediction was published. If it is higher, share price may increase. If it is lower the price will undoubtedly fall.

It is in this environment that manager’s look to improve their returns though not always by improving their operating profit.

Research & Development.This cannot be capitalised even though it may be an investment for the future. This is because of the uncertainty of it the research proving to be viable; many tests will be made before the solution is found.Development can be capitalised (value added to the Balance sheet) if -1. There is a clearly defined project2. The related expenditure is separately identifiable3. The outcome has been assessed with reasonable certainty with regard to technical

feasibility and commercial viability in light of market conditions, public opinion, consumer and environmental legislation.

4. The aggregate of deferred development costs, further development costs and related production selling and administration costs is reasonably expected to be exceeded by future sales or other revenues.

5. Adequate resources exist or will be available to complete the project and provide working capital.

Off Balance Sheet Transactions

High gearing ratios in the UK attract attention because it is seen as risky to be long term loans or many short term loans. Equally, a company who is highly geared is suspected of being about to issue a shares option (sell more of its authorised level of shares) to reduce the gearing.

To cover borrowings that will give the appearance of being highly geared, companies may attempt the following Off Balance Sheet Transactions -

Quasi Subsidiaries - 1. Here the parent company attempts to cover he fact that it is the controlling

interest in a smaller company. If it declared it’s controlling interest the subsidiary would require to be consolidated in the group P&L account and Balance Sheet. Thus any borrowings would be part of the consolidated group.

The parent company can hold all the ordinary shares but its bank or investment managers can hold a number of other shares that on paper give them the controlling interest. The parent company however controls the board so controls the company. On paper the investment bank holds more shares and the subsidiary is not considered to be owned.

2. In this example, the parent company sets up another company and sell it some of its assets. The other company is funded by loans from and by purchasing from the parent company is putting money back into it. The parent company then manages the assets for the subsidiary and if the subsidiary sells the assets, it pays the money back to the parent company through some management charge.

3. Where a parent company sets up in a joint venture and leases back its assets from the subsidiary that has purchased the asset, this is shown as an investment in an associated company. If, The parent company is the lead partner and exerts a dominant role, or Can take back its asset under beneficial terms (not full market value), or There is an unequal share of profits, losses, dividends and or loan guarantees, Then the parent company must register the company as a subsidiary under FRS 5 because in all the scenarios, the parent company has control.

Consignment Inventories - Here the parent company sends the subsidiary goods for sale but does not charge for them until they are sold. The subsidiary needs neither show the goods as an asset or a debt.FRS 5 requires that When the goods can be returned without penalty, they need not be recorded as an

asset When the goods must ultimately be paid for, they must be recorded as an asset.

Sale and Repurchase Agreements - here the company sells part of its assets that never leaves its control and buys them back at a later date plus interest. This is a loan and should be shown as such in the balance sheet with the accrued interest being entered in the P&L account.

Debt Factoring - debt can be sold to factoring houses to improve cash flow. If the factor has no right of recourse on the selling company should they be unable to collect the debt then this is a straightforward sale of debt.If the factor has s right of recourse then, FRS5 require the parent company keeps a proportion on the balance sheet. The prudent approach is to keep the full amount on and show the factored debt as a cash loan. When the debt is recovered and the liability ceases, the debt is removed and any shortfall (the difference between the debt and the a=mount paid by the factor) is recorded in the P&L.

Accounting for Acquisitions and Mergers

Acquisition - this is where one company takes over another buy purchasing more than 50% of the shares. If the predator raises its share capital to purchase the other company, the difference between the par value and the share price goes into the Share Premium Account. Anything paid over the Net Asset value for the company is Goodwill and will show on the consolidated balance sheet.

Mergers presume agreement and goodwill will not feature as both companies are joining in mutual agreement. FRS6 sets out the guidelines for mergers -1. Neither party should be seen to be acquiring the other2. Neither part should dominated the management of the combined entity3. Each should be of comparative size that neither dominates because of its size4. Each of the parties receives equal share in the new entity5. No equity shareholders retain any material interest in only one of the combined

company

Goodwill

Goodwill is the excess over the book value that a company is prepared to pay for another. It is an intangible asset and has to be accounted for by either1. Writing off the purchased goodwill at the moment of acquisition again the group

reserves; or2. Capitalise the amount paid as an asset and amortise (depreciate) the asset over its

useful economic life.

The first method reduces the overall value of the group and has a negative effect on the shareholders stake in the combined company.

The second method requires that the asset is written off over the lower of its economic use and 20 years. To go beyond this period it must be demonstrated that there is good economic reason and in any event, the period must not exceed 40 years.

The period of amortisation must be subject to an impairment test. This is a detailed consideration of the inherent value of the goodwill. If there is no value then it must be written off.

Brands

Brands are the name of consumer products which, because they are so well known, can be seen as having value to the companies that own them.

The construction of brands value on the balance sheet can have the following effects

fro a company The brand value on the balance sheet raise the overall value of the company and

can ward off predators The added value can drive up the share price making their shares more attractive

when issuing shares for another company. It raises the overall value of total assets. This allows the gearing to change and

increases the owners equity Brands are a component of goodwill and can be taken from this figure and

capitalised separately on the balance sheet. This lessens the impact on reserves or profits as the goodwill is written off.

Brands are valued at historic cost or Earnings MethodHistoric Cost - all the money spent on developing and maintaining the brand are capitalised. R&D and marketing costs which have previously been written off are written back into the value of the brand.Earnings Method - Management attribute the actual earnings of the company to specific brands and then apply a multiplier which reflects the brand strength. This the guess upon guess method.

Operating and Financial Review

Environmental Reporting

MODULE 9

COST CHARACTERISTICS AND BEHAVIOUR

Variable and Fixed Costs - Variable costs are those which vary directly with the level of output i.e. materials, direct labour.Fixed costs are those that remain constant regardless of output i.e. managerial salaries, rent rates etc.*Whilst fixed costs remain constant regardless of output, the amount of fixed costs per unit produced varies with output*

Direct and Indirect Costs -Direct costs are those that can be traced in full to the item produced i.e. material and direct labour. This is also known as the Prime CostIndirect costs are those that cannot be directly attributed to the item produce and include such items as supervisors wages, cleaning materials and rent- these are support costs which if not incurred the item could not be produced.

Traceable and Common CostsTraceable costs are those costs that can be directly traced into the item being produced. Common costs are those costs that are indirect and incurred to support the business

Period and Product Costs Period costs are those costs that are incurred in support of the production but are accounted for in time periods such as some types of inventory that cannot be accurately measured per item produced - Foundry sandProduct costs are those that can be directly attached to the product.

Controllable and Non Controllable CostsControllable costs are those that the manager has direct control over such as overtime.Non-controllable costs are those that the manger has no control over such as the share of rent apportioned to his unit or the interest rates charged by banks on loans.

Standard and Actual CostsStandard cost is the benchmark cost for the item, the expected cost.Actual cost is the cost to manufacture, which is measured period by period.

Engineered and Discretionary CostsEngineered costs are those that must be incurred in the production of the item such as machining costs. Discretionary costs are those, which must be accounted for but need not be included in all time periods or all items produced. These include R&D admin and machine maintenance.

Break Even Analysis

On a graph, it is the point where the Sales revenue line crosses the Total costs line. Profit is the difference between the Sales revenue and the total costs. * Remembering that in plotting the graph, total costs start at the point of fixed costs.

Profit / value ratio - this measures the impact of volume on profit. It is also the method of measuring contribution to fixed costs.P/V ratio = Profit/Sales Price (Sales Price - variable costs / Sales Price)

Calculating the Break Even Point in SalesSales = Fixed Costs + Variable Costs + ProfitBreak Even Sales = Fixed Costs + Variable Costs

Calculating the Break Even Point in outputContribution Margin = Sales Revenue - Variable costsBEP = Fixed Costs/ Contribution Margin Ratio (see above P/V ratio)

Break Even Analysis and the Multi Product Firm

In this scenario, the contribution margin ratio is calculated by weighting the 2 products and using the above formula to get the ratio

MODULE 10

ALLOCATING COSTS TO JOBS AND PROCESS

Plant wide versus Departmental Rates

Plant wide overheads come from both manufacturing - screws, maintenance factory lighting and heating etc.; non manufacturing overheads come from all the ancillary tasks such as administration. These overheads are gathered into cost centres and then totalled. This is then divided by the number of units to be produced to give the overhead allocation per unit produced. If the actual overheads incurred are more than that budgeted for then the shortfall is charged to the profit and loss account.

Departmental overheads reflect the products actual use of each department and takes an share of the overhead.

The Direct Method

The service departments overheads are emptied into each of the production departments based on an appropriate activity i.e. Personnel’s overhead dumped into each of the production departments by apportioning the share by the number of employees in the department divided by the total number of employees in production.This figure is then divided by an appropriate activity base for production i.e. the number of machine hours to be used in the year to give a pre determined overhead rate. Every product that passes through each of the production departments will be allocated their overhead rate.

The Step Method

This works in a similar manner to the Direct Method however, recognises that not only do the production departments use the services of the service departments but so to do the service departments themselves.The sequence used is either to select the service department with the largest overhead and allocated in descending order or; select the service department that renders the highest percentage of services to other service departments and end with the lowest.

Remember - when allocating the costs, ignore the consumption of its own resources i.e. for personnel, the total number of employees does not include their staff; and when the departments overheads have been reallocated, they are closed down.

Joint Products and By-Products

A Joint Product is one that is produced alongside the intended and is planned for - Aircraft fuel and petrol.A By Product is one which emerges from a process designed to produce another product - woodchips from a wood yard. There is no production overhead for this product as it has not been a planned production. If sold, is additional revenue that can be deducted from the cost of sales and improve the gross profit margin.Any unsold by product would have no value as inventory.

The problem is how to allocate costs to the Joint products.

Equal Shares - each product takes an equal proportion of the overhead costs

Physical Characteristics - the overhead is apportioned according to some physical characteristic such as weight or volume

Sales Value at Split Off - the overhead is apportioned according to the sales value for each product.

Ultimate Net Sales Value - if the products are processed further, after the additional process costs are taken from the new sales value leaving the ultimate net sales value. This in turn is divided by the total for the products and multiplied by the original production costs to provide individual production costs.

Process Costing

This is the method of costing items that are continually produced and cannot be costed as an individual item such as paint, oil etc..

Process Costing and the Equivalent Unit

An equivalent unit is an assessment of the degree of completion of a unit under each major component of cost. How many units have been completed in the cost of materials and how many have been completed in the cost of Labour/conversion. 1. Opening work in progress has to be finished and this is the material and work

required to finish the Opening work in progress2. The volume of units delivered during the period has the number of units

unfinished deducted from it to give the number of units started and completed.3. Closing work in progress has to be finished and this is the material and work used

to get them to the stage of completion at the end of the period.4. The three are totalled for Material and Labour/conversion costs and this gives the

Equivalent Units of Production.

Cost per Equivalent Unit

This converts the volume of goods to cost of goods through the process. 1. Complete the Equivalent Units statement2. Total the Costs to be accounted for - Value of opening work in progress and the

costs incurred during the year.3. The Costs to be accounted for is the divided by the Equivalent Units of

Production to give the cost per equivalent unit, which are added together to give the Total cost per equivalent unit.

4. The individual cost per equivalent unit is multiplied by the Opening work in progress, Units started and completed and Closing work min progress; these are then added up and down and across.

5. The totals across give the Value of Units shipped out and closing inventory (closing work in progress).

Activity Based Costing

ABC focuses on the activities that cause the overhead costs rather than the products. The product consumes a percentage of the activities of departments and these activities cause the costs to be incurred. Rather than each product share the cost of the activities, the product cost should reflect the proportion of these activity costs it incurs.

Advantages -1. Cost of product becomes the principal goal and is not subservient to inventory

valuation. 2. Different activities have different cost drivers i.e. costs fall on the product that

consumes the cost driver.3. ABC covers all activities - not only in the production process but also the design

as some products incur more design (driver) than others.4. Allows products to be loaded with the costs they incur reflecting their true cost5. Provides accurate product costs which may lead to strategic planning of products.

Methodology -1. Identify the cost drivers from the information available - this is the total cost of an

area of the manufacture process from design to shipping.2. Calculate the cost for each driver - this is the total cost incurred by the department

divided by the total amount of it’s uses i.e. machine hours, to give the cost driver.3. Divide the individual usage of the product per driver by the total output per

product then multiply this by the total cost for the driver (from 2 above).4. Carry this out for all cost drivers and products.5. Add the cost of material, labour and each cost driver for each product to give the

total cost per product.

MODULE 11

COSTS FOR DECISION MAKING

The Dilemma of the Denominator

Here the problem of the numerator and denominator is what figure to use to calculate the cost of the product is it the budgeted or actual manufacturing (or non manufacturing ) overhead that is divided by the budgeted or actual output to give the cost of the product.

The numerator - the cost of overhead can be determined more easily as prices tend not to fluctuate over short periods and can be predicted if costs are subject to contract (the price you buy in your goods at).

The denominator can fluctuate from month to month as you cannot guarantee to produce the same amount every month or sell the goods produced. Downtime can result in shortfalls of production.

Absorption or Full Costing - Each product has the fixed production cost absorbed into its overall cost. If the product is over produced then there is said to have been a over absorption of the fixed production costs by each unit (more units mean that the fixed cost per unit is reduced). This variance in the denominator (number produced) has to be accounted for and is done so by deducting the variance from the other expenses in the P&L Account.

The extra products are put into the inventory. Each is valued at the full cost of production

If, in the next period production is less to account for the over production and the goods produced plus the goods in inventory are sold, the variance is added back to the expenses in the P&L account thus reducing the profit.

Variable CostingFixed production costs are not added to the individual product but deducted from the gross profit in the P&L account after sales at the end of the period under review. The goods sold after the variable cost of sales is deducted, are said to leave a Contribution Margin (to fixed and other costs).

From the Contribution Margin, fixed and other expenses are deducted to leave a profit.

If there is an over production, these goods are put into inventory at the cost of production without a share of fixed production costs.

If in the next period there is an under production and the goods are removed from inventory for sale, then the total sales less Variable costs gives the contribution to fixed and other costs which is again deducted to give the profit.

Managerial Implications of Abortion and Variable Costing

This is often not a choice for managers but decided by fiscal policy. As absorption costing has a higher inventory cost and therefore gives higher profits (which are

taxable) then this has to be the method used.Absorption costing influences bottom line profit. Profit is influenced not only by sales but by production because any over production adds to inventory as more fixed costs are parked in inventory. Cash however stored in inventory does not replenish stocks for production and when inventory is used because sales exceed production, profits fall as the variance has to be taken account of.

Variable costing on the other hand is sales driven, when sales rise, so do profits.

Developing an Analytical Framework

Non routine decisions re best approached in a analytical manner using a framework

1. Define the problem and list all feasible alternatives.2. Cost the Alternatives - the relevant costs are those that differ between the

alternatives under review - these should be listed3. Assess the Qualitative Factors - not always the bottom line remember staff and

social implications4. Make the Decision

Opportunity Costs

This is the opportunity forgone and it may be possible to identify costs for not choosing the alternative that may be relevant in the decision making process. These are costs that if incurred would afford the opportunity to undertake other work which may prove profitable also.

Department versus Company

Cost decisions must take into account the effect on the company as a whole not just the department concerned.

Sunk Costs

Costs which have been incurred are Sunk Costs and should not be taken into account looking for relevant costs. These costs have to be written off, the only Relevant costs are future costs and involve cash spent or cash saved.

Management Decisions in a Action

Relevant costs are - Future costs - because old costs cannot influence decisions Cash costs - because these effect the cash flow and the real money implications of

a decision. Avoidable costs - costs that differ among alternatives. If a cost is unavoidable it

is not relevant for the decision under review because it will be incurred whatever option is selected. Only those costs that would not be incurred if another option is selected should be taken into account

Costs which differ among alternatives - is another way of looking at avoidable

costs. If the same cost is incurred in all options, ignore it as it causes confusion.

Closing Down a Unit

When faced with the alternative of closing a plant either temporarily or permanently, the following must be considered before coming to the decision -1. How long should the shut down be permanent or temporary2. Does the plant contribute to fixed costs3. What are the costs associated with closure

The Special Sales Order

It is important to establish the variable cost of production for the special sales order. The other costs not incurred such as Selling and Administration that are not incurred must not be included in the cost of production. The figure attained for the variable cost is deducted from the revenue the order generates to give the contribution to fixed costs.

A full cost of production is necessary for long term costing as all fixed and variable costs must be recovered and this is accounted for by using the absorption method.

Further Processing

The incremental approach must be used to calculate if further processing is cost effective. This is done by subtracting incremental costs from incremental revenue.

MODULE 12

BUDGETING

Why Bother with Budgets?

Co ordination - of the various departments. Everyone has to focus on working towards a common and agreed goal that is attainable within budgetary constraints.

Planning - ensures that there is adequate resources and that all departments are utilising those resources in a cost efficient manner within the agreed budget.

Motivation - Once agreed and broken down into departments, it acts as a target for everyone to aim for.

Control - allows managerial control over departments by providing a benchmark for departmental managers to achieve.

The budget is an action plan over an agreed time frame

Why Budgeting gets a Bad Name!

Time Taken - because of the process budgeting must go through several departments and drafts before it is finally agreed. This can result in it being out of date and not what the department manager originally proposed.

Lack of Top Management Commitment - the corporate expense account and senior management social functions that are extravagant are resented by department managers who are under pressure to work within limited budgets and resent this spending.

Punishment - managers often see reductions in their budget as control methods only, used to minimise resources whilst expecting to maintain or increased productivity. This can be alleviated by consultation to establish the needs of a department before any reduction in budget.

Responsibilities are Blurred - a departmental manager should be responsible for costs in his or her own area. Shares of corporate expenditure or R & D over which he has no control should come from a central budget with a person responsible for the budget.

Moving Goalposts - when there is a major change in circumstances over which the budget holder has no control, the plan can fail. The budget holder should not be held responsible and the company should 1. Stick with the original budget but report the variance between the planned and

actual budget. This variance is removed from the figure and only any variance over which the manager has control should be used to assess performance (see Module 13)

2. Implement a rolling budget whereby as each month expires, anther is added 12 months on.

Budgeting Rewards Inefficiency - budgets should not be increased by a blanket percentage each term as inefficient departments get an increase on their inefficient processes. Instead, departments whose costs are not engineered but are discretionary, should produce detailed bids for their increase.

Budgeting in Action

From the reports submitted by each department, prepare a Sales Budget for the year by quarters1. Multiply the Turnover by Price to obtain the Recorded Sales2. Add the cash inflow from the previous period to the cash collected this period

This provides the quarter and annual sales, the cash collected each quarter and for the year and the debtors.

The Production Budget is then created. From the reports submitted - 1. Add the planned inventory for each quarter to the planned number of units to be

sold2. From this total, take away the previous quarters inventory (found in the balance

sheet) to give the total number of units to be produced each quarter and in total.

The Direct Materials Budget can now be created as we know the number of units to be produced.1. Multiply the units required each quarter by the amount of material required in

each unit.2. Multiply this by the cost of the material per quarter to give the total cost of

materials consumed.3. Subtract the planned inventory of materials per quarter and the total cost of

materials purchased is given

The Cash Outflow Budget can now be constructed. 1. The cost of materials purchased per quarter is divided into the amount to be paid

to creditors each quarter2. This first figure is then subtracted from the creditors at the end of the last

financial period to give the cash outflow for the first quarter3. The balance of the quarters outgoings is added to the amount calculated for the

next quarter and so on for the year to give the total cash outflow per quarter

The Direct Labour budget can then be constructed.1. The units required to be produced is multiplied by the hours to produce each unit

to give the total number of labour hours2. This figure is then multiplied by the cost per hour to give the total cost of direct

labour

The Manufacturing Overhead Budget can now be constructed -1. The total cost of direct labour is multiplied by the Absorption Rate for Variable

Overhead (this is found in the production report and this either the variable overhead rate multiplied by the number of planned units in closing inventory or; as in the module, the variable rate is divided by the labour rate to give the cost per hour for variable overheads). This gives the total Variable Overhead.

2. The fixed overhead is then added to this figure 3. And the depreciation is subtracted to give the final figure for Manufacturing

The Selling and Administration Budget can now be created. Total sales is found from

previous calculations for each quarter and headed at the top of the table -1. The Selling and Administration variable costs are added (this is the planned

increase in expenditure) to R & D costs2. Fixed costs - salaries, consumables and advertising are then added to give the total

cost of Selling and administration. This total at the bottom of the column gives an indication of the costs incurred in selling and administration by sales.

The Closing Inventory Budget is then calculated.1. The direct material required in inventory for each quarter is found from previous

calculations and multiplied by the cost2. The number of finished goods kept in inventory is found for each quarter and

multiplied by the variable cost per unitInventory is valued at the lower of - cost to produce or market value. If to is market value and the market price drops, the difference must be written off in the P & L account

The Cash Budget or Cash Flow Statement for the year can now be calculated - 1. The cash generated from Sales for the quarter is added to the opening balance

from the previous period to give the cash inflow2. The cost of Direct materials, Direct Labour, Manufacturing then Overhead Selling

and Administration overhead is all deducted to give the closing balance for the period.

The Budgeted Profit and Loss Statement can now be calculated -1. Starting with Sales Unit’s the sales revenue has the variable cost of Sales

Manufacturing deducted2. The Selling and administration costs are deducted to give the Contribution Margin3. Fixed cost of sales - Manufacturing and Selling and Administration - are then

deducted from the Contribution margin to give the profit (or loss) before tax.

The Budgeted Balance Sheet can now be constructed - 1. Starting with Plant and equipment, accumulated depreciation is deducted 2. Inventory - raw materials and finished goods are added3. Debtors are added4. Cash in hand is added (or subtracted if a negative balance)This gives the Total assets for the company1. Ordinary Shares value has the retained earnings and creditors added to give the

Total equity and Liabilities

Discretionary Expenditure and Zero Based Budgeting

Engineered costs are those that are directly associated with the production of the goods. Discretionary costs are those costs that do not need to be incurred but those such as R & D, marketing legal services etc..

These costs are difficult to account for and control as they are incurred over several accounting periods.

Accounting for these costs is ZBB. This allows senior management the opportunity to identify an amount available for discretionary spending and have the non production departments present bids for same.

These bids are then scrutinised by senior managers who decide as to where the money is spent in keeping with the companies objectives.

MODULE 13

STANDARD COSTING Standards are set from the following -

Normal or Operating Standard - those that could be expected to be achieved if every thing went efficiently and taking into account that things can go wrong

Materials Standard - Quantity, quality and price agreed for materials

Labour usage and price standards - Engineering study to ascertain how long it takes to produce the goods and the cost and quality of labour

Overhead Standard - both variable and fixed overheads depend on 3 components 1. Budgeted cost of each overhead2. The allocation key used to allocate the overhead to the product3. The volume expected of each allocation key to be used

Flexible Budgets

Where actual production does not match budgeted production, a flexible budget is constructed to compare the variance with the actual budget.Here the flexible budget is the cost to produce the actual amount produced using the budgeted figures. The actual costs incurred are subtracted from the flexible budget to give the variance.This figure will show the amount of over or under spend incurred and can be investigated further.

Variances: Materials and Labour

Material costs can be more or less than budgeted for only 2 reasons - 1. Material Efficiency Variance - Actual production used more or less than planned

and/or2. Material Price Variance - The purchase price of the material was more or less

than budgeted for.

This can be analysed -

Material Efficiency Variance = (Standard Quantity - Actual Quantity) X Standard Price per unit = (SQ - AQ)SP

Material Price Variance = (Standard Price per Unit - Actual Price per Unit) X Actual quantity Used = (SP - AP)AQ

If the resultant figure is negative then the variance is adverse (cost above standard) with positive favourable. The total material variance is found by subtracting the MP from the MV.

Once the variances have been found they have to be explained (qualified)

Labour Cost variances are caused by only 2 reasons -1. Labour Efficiency Variance - Actual production requiring more or less time than

planned 2. Labour Price Variance - Actual rates paid were more or less than planned.

Labour Efficiency Variance = (Standard Time Allowed - Actual time taken ) X Standard rate per hour = (ST - AT)SR

Labour Price Variance = (Standard Rate per Hour - Actual Rate per Hour) X Actual Time Taken = (SR - AR)AT

If the resultant figure is negative then the variance is adverse (cost above standard) with positive favourable. The Total Labour Variance is found by subtracting the LP from the LV.

Once the variances have been found they have to be investigated and explained (qualified). It is important to remember when calculating variances to remember to use figures (costs) that reflect the managers responsibility.

Efficiency Variance measures the financial impact by using more or less material or labour to produce the goods. Hence the reason that a standard price is used to calculate the variance.Price Variance measures the change in price in relation to the actual quantity used. Hence the Actual quantity is the multiplier.

Variable and Fixed Overhead Analysis

Variable overheads - those that vary with the rate of production - can be subjected to variance analysis to examine the difference between actual overhead and how much should have been incurred based on the allocation key (allocation rate).

How much overhead should have been incurred?

The Standard Cost of the variable overhead is found by multiplying the number of goods produced by the number of hours required to produce the good and the allocated overhead rate (allocation key - the rate per hour overhead is applied).

This figure then has the Actual Cost of the variable overhead subtracted from it.

As an allocation key (direct labour hours) has been used to apply variable overheads, the Efficiency and Price (or Spending Variance can be analysed further -

Efficiency Variance = Standard Cost of flexible budget time allowance for units produced (number of goods produced X hours to produce X overhead rate) minus Standard cost of actual time taken to produce units

Fixed Overheads are budgeted based on planned production over the year and allocated using the allocation key chosen i.e. direct labour hours. When the budgeted overhead does not match the actual overhead, ten this must be investigated.

The actual overhead incurred is subtracted from the budgeted overhead to give the Spending Variance. This must be investigated further to establish where the overheads have been incurred. It ignores the fact that more fixed overheads have been applied to the product than were budgeted for - unless the overheads themselves have increased, the increase is due to the fact that more products have been produced and the cost has included the fixed pre determined overhead rate for the planned production volume.

To calculate the variance, the overhead rate applied to the units produced is subtracted from the budgeted fixed overhead. A negative figure (actual overhead is greater than budgeted because output is greater), is seen to be favourable as output is greater than planned.

Carry out the exercises in the Module.

Sales Variances

Sales variances show the effect of sales mix and volume to the contribution margin when it deviates from the budgeted plan. The total contribution earned from sales depends on the contribution per unit and the volume of the unit sold.

Contribution Variance = Difference in contribution margin (actual - planned) multiplied by Actual Sales in units.

The Lower price goods variance is subtracted from the higher to give the actual variance.

Volume Variance = (Actual Sales - Budgeted Sales) X Budgeted Contributing Margin per Unit. Again the lower priced item is subtracted from the higher to give the variance.

By comparing the Contribution and the Volume Variance, the manager can assess which has had the greater effect on contribution margins.

It is possible to take this further by investigating the Sales Volume Variance (how many goods have been sold compared to those budgeted) and the Sales Mix Variance .

Sales Quantity Variance = (Actual Sales - budgeted sales) X Budgeted weighted average contribution margin per unit. Again the lower is subtracted from the higher.This treats all goods sold as equals and shows the effect of an overall increase or decrease in sales on the contribution margin.

Sales Mix Variance = (Actual Sales - budgeted sales) X (Budgeted contribution margin per unit - weighted average contribution margin per unit). Again the lower is subtracted from the higher.

By subtracting the Sales Mix Variance from the Sales Quantity you can check that it matches that figure achieved from the earlier calculations.

MODULE 14

ACCOUNTING FOR DIVISIONS

Divisions - Advantages

Specialisation - dedicated areas or departments where skills are harnessed to the particular problem or job

Size - scale of an organisation allows local management to react to local problems with their knowledge which does not come from the centre

Motivation - working away from the centre permits decisions to be made locally

giving autonomy and a sense of control of ones destiny Sharper decisions - these are made locally at the time, not going to the centre by

way of report for a decision before coming back down Career mobility - skills can be learned within the division that can be taken to

other parts of the organisation particularly management.

Disadvantages

Lack of Control - the division must have control of its day to day management. It may also have some strategic control which might not be in keeping with the organisation as a whole but more with bettering the division and its profitability

Cost - the division may incur other costs such as R & D or HR these may be available at head office and duplicate the work being done there

Internal Rivalries - any performance measurement system may result in the division looking for cheaper suppliers out with the organisation to better its profit margin but to the detriment of the organisation as a whole

Types of Divisions

1. Cost Centres - are only responsible for the incurrence of costs and have nothing to do with the manufacturing process and generation of revenue - auditing office or further processing plant

2. Revenue Centres - are only responsible for the generation of funds without any responsibility for the underlying costs of the or how they are made up - ticket sales offices

3. Profit Centres - are assessed on profit, that costs are matched by sales 4. Investment Centres - where net assets are taken into account when evaluating

performance. This allows not only profitability to be assessed but the use of assets also. This is found by establishing what is the Return on Investment (assets) i.e. what percentage of assets is the profit returned = Profit / Assets X 100

Defining Profit and Investment - only those revenues costs and net assets over which the manger has control should he be held accountable for and should be included in the calculations.

Asset Base Valuation - as plant etc is subject to depreciation, so the value of the net assets fall every year. If profit remains the same then the ROI will show an increase each year. This is in fact a false increase but may inhibit managers from replacing assets.

Residual Income - a company will charge each division interest on its invested capital, at the rate of interest being the companies cost of capital. Profit must exceed the R.I. Investment decisions that offer a return that exceeds the companies imputed (assigned) rate.

1. Controllable profit is divided by Investment in net assets and multiplied by 100 to give the R.O.I.

2. The R.I. is calculated by establishing the return on Investment in net assets from the imputed rate (Net assets X Imputed rate)

3. This figure is subtracted from the controllable profit to give the R.I.

R.I. Allows management to look at investment opportunities to ascertain if they exceed the return of imputed rate of interest -

1. The cost of the investment opportunity is added to the net assets and the anticipated profit to the profit.

2. The R.O.I. Is calculated before and after the additions to compare the ROI3. The R.I. Before investment is calculated4. The R.I. after the investment is calculated5. This gives a monetary value as to the R.I. that can be compared to establish if the

investment will generate more profit.

The ROI allows the organisation to ascertain the effective use of assets by the division. The RI allows the use of the assets to be compared to other divisions and to establish the viability of investment opportunities.

Criteria for Establishing a Transfer Pricing

Market Price - where the price on the market is competitive for a good of comparable quality

Cost Based Price - Full cost - fixed and variable costs though this may cause problems if the receiving department had to drop its fixed costs for a special sale, then why should the preceding department have its full costs covered?Variable Cost - here the receiving department pays only the variable cost for the product and can sell it on adding its full costs but is this fair?

Negotiated Cost - fight it out and decide a price

The International Dimension

Taxation - this varies from country to country and can effect the profit of a division as it pays tax for the country where it is based. Where one country has markedly lower tax rates than another, and the company wishes to minimise tax paid, it can sell products to the country in the high taxation country at over inflated prices. This has the effect of increasing profit in the low tax paying country and maximising profit after taxes. In the other country, it has the opposite effect, high price of goods bought in reduces profit and lowers tax liability.

When the department in the country with high tax rate is transferring the goods to the country with the low tax rate; it sells them at a low transfer price. This reduces the earnings from sales and so tax paid is lower. The receiving country with the low tax rate has a low cost of goods bought in, profit from sales is maximised and tax paid is lower.

MODULE 15

INVESTMENT DECISIONS

The Investment Process

Search - finding suitable alternatives to invest in Evaluation - the process of deciding which option is the most economically

viable Control - normal financial budgetary procedures to establish that the project is

within budget - both capital and cash flow

Concept of Present Value

A sum of money toady, invested in a bank at an interest rate will have a value of the sum plus interest for the term that it received the interest. By calculating the return, we can ascertain what this future value will be and technically spend the return today, invest the money in and the interest covers the spend today.

Net Present Value

NPV > 0 - The rate of return is greater than the cost of financing the project - acceptNPV < 0 - The rate of return is less than 0, the cost of financing is less than the cost of the project - rejectNPV = 0 - The rate of return is the same as the cost of financing the project - reconsider

The amount to be invested will offer a return on the investment. If this is greater than a zero return, we could borrow the total amount (investment + interest accrued), spend it and invest the original sum to cover the cost.

Discounted Cash Flow Rate of Return (Internal Rate of Return)

This calculates the interest rate at which a project will break even - what return would we need to get to cover the cost of borrowing.

DCF RR > Cost of capital: accept the projectDCF RR < Cost of capital: reject the projectDCF RR = Cost of capital: reconsider as this is the breakeven point

By calculating the DCF RR we can see what interest rate the project is returning. This has to be greater than the cost of the borrowing over the period involved.

NPV gives a return as a cash value whilst DCF RR gives the return as a percentage. When comparing 2 projects it is important to remember the scale involved and then analyse the projects. This is done by establishing the difference between the 2 projects and calculating the NPV and DC RR.

The difference has to be appraised, the higher costing and returning project will provide all that the lower provides plus the difference (at a cost of the difference also). The difference on the investment can be calculated for the NPV and DCF RR. The NPV when calculated is subtracted from the NPV of the lower project to ascertain how much more if any, the higher project returns. The DCF RR shows the rate of return if the investments were the same level.

Risk

The evaluation of risk has many models however all require judgement of management. The 2 covered for the course are -

Do no further analysis as all estimates are prepared on the best information available. Management then has to make its decision based on the relevant evidence.

Apply the ‘high hurdle’ approach where projects are graded high medium and low

risk. The higher risk projects have to have a higher rate of target return.

Pay Off or Payback Period

This is the time taken to recover the original investment - when we get our money back.

In its simplest form, the initial investment has the cash flow added cumulatively. The interest can be deducted from the cash flow using the Present Value table to give an accurate cash flow.

The risk can be classified in terms of the length of the payback period and should be used in conjunction with the DCF RR and PV.

Sensitivity Analysis

This looks at varying the factors in the investment such as varying the cash flow by a positive and negative amount to see the effect on the overall return. All the variables can be altered in some way and it is important that they all are not varied as the original project can become obscured.

Risk Analysis

This is getting a range of values that are likely to occur for some variable such as the selling price. These are given a probability, multiplied by the selling price to give an expected value. The values are added to give a most likely value

Key Investment Factors

1. Capital Investment - is the total amount of fixed (the loan) and working capital (on going costs both outgoing and incoming) required for the project. It is critical that the timing of cash flow requirements are correct as delays in completion of the project, delay any income to be generated and put the projected budget off course.

2. Operating Cash Flow - this is the cash generate from the project and its cash outflows. It is not depreciation but must include tax and associated cash expenses.

3. Investment Life - the determinants are Wear and tear Technical obsolescence Market - the product is no longer in demand

4. Cost of Capital - NPV / DCF RR

Projected Average Cost of Capital

1. Fixed Interest Loan - cost of the loan or debenture plus the cost of servicing the loan or debenture plus tax.

2. Fixed Interest Dividend Shares - preference shares . The cost of is the net interest payable plus an allowance for raising the shares plus tax.

3. Residual equity Shares - a new issue of ordinary shares. The dividend will that

determined by the board, however there will be an assigned rate of return that the company must seek to achieve.

4. Retained Earnings - profits

The average cost of capital is calculated by proportioning the sources of finance to get an estimated cost for each source. These are added to give the average cost of financing the capital.

Opportunity Cost, Risk and the Cost of Capital - is applied when a company decides that irrespective of what it costs to raise capital, they should only be used internally if the return is at least as good as that which could be achieved if the funds were invested out with the company.

MODULE 16

NEW DEVELOPMENTS IN MANAGEMENT ACCOUNTING

Target Costing - the product is costed at a price the market will accept and costs to manufacture are adjusted accordingly.

Life Cycle Costing - the cost of the product includes all costs that will be incurred in the life of the product such as development, support the production of spare parts after the product is no longer being produced etc..

Throughput Accounting - takes into account the rate at which cash is generated and measures the performance. Depreciation and similar costs that are fixed should be excluded from measuring

performance. Inventory is not a measure of performance it is a cost Volume of sales not contribution to fixed costs generates more cash for the

company. Through put should identify a bottleneck and calculate using ratio analysis to establish which product earns money. This is carried out by calculating-

1. Return per Factory hour = (sales Price - Material cost) / Time spent at bottleneck2. Cost per Factory Hour = Total factory Cost / Total Time Available at the

Bottleneck 3. Throughput Accounting Ratio = Return per Factory hour / Cost per Factory Hour

If it is greater than 1 then the product earns money.

Costing for Competitive Advantage

1. Production Facilities - capacity and ability to meet specification2. Labour skills3. Sourcing of Supplies4. Introduction of TQM, JIT5. Outsourcing6. Suppliers limitations