Task 1:

3.1 Budgets and make appropriate decisions

‘The term ‘fixed budget’ means the following:

a) The budget is prepared on the basis of an estimated volume of production and an

estimated volume of sales, but no plans are made for the event that actual volumes of

production and sales may differ from budgeted volumes.

b) When actual volumes of production and sales during a control period (month or four

weeks) are achieved, a fixed budget is not adjusted (in retrospect) to the new levels of

activity.

A flexible budget recognizes the existence of fixed, variable and mixed(semi-fixed, semi-

variable) costs, and it is designed to change so as to relate to the actual volumes of

production and sales in a period.’ (BPP, p.182)

‘Budgetary control is the practice of establishing budgets which identify areas of

responsibility for individual managers (for example production managers, purchasing

managers and so on ) and of regularly comparing actual results against expected results, the

differences being variances.’ (BPP, p.184)

The budget control (variance) analysis should be as follows:

Fixed budget Flexible budget Actual budget Budget variance

Production

(units)

4,000 6,000 6,000

Variable cost

Direct material 12,000 18,000 10,500 7,500(F)

Direct labor 8,000 12,000 8,500 3,500(F)

Maintenance 2,000 3,000 2,500 500(A)

Semi variable

cost

Other cost 1,500 13,500 5,000 8,500(F)

Fixed cost

Depreciation 4,000 4,000 4,500 500 (A)

Rent and rates 3,000 3,000 3,500 500 (A)

Total costs 30,500 53,500 34,500 19,000(F)

Note: (F): a favorable variance, (A): unfavorable variance

Summary of the possible causes of variance:

Variance material price Favorable

Unforeseen discount received

Greater care taken in

purchasing

Adverse

Price increase

Careless purchasing

Change in material standard

Change in material standard

Material usage Material used of higher quality

than standard/less wastage

More efficient use made of

material

Errors in allocating material to

jobs

Defective material

Excessive waste

Theft

Stricter quality control

Errors in allocating material to

jobs

Labour rate Use of apprentices or other

workers at a rate of pay lower

than standard

Wage rate increase

Excessive overtime, with

overtime premium charged to

(direct) labor costs

Idle time Machine breakdown

Non availability of material

Illness or injury to worker

Labor efficiency Output produced more quickly

than expected, that is actual

output in excess of standard

output set for same number of

hours because of worker

motivation, better quality of

equipment or materials

Errors in allocating time to

jobs

Lost time in excess of

standard allowed

Output lower than standard set

because of deliberate

restriction, lack of training, or

substantial materials used

Errors in allocating time to

jobs

Fixed overhead price Savings in costs incurred Increase in cost of services

More economical use of

services

used

Excessive use of services

Change in type of service used

Table 1: summary of the possible causes of variances

3.2 The calculation unit costs and make pricing decisions using relevant information

‘Direct material costs are the costs of materials that are known to have been used in making and

selling a product (or even providing a service)’ (BPP, p.152)

‘ Direct labor costs are the specific costs of the workforce used to make a product or provide a

service. Direct labor costs are established by measuring the time taken for a job, or the time

taken in ‘direct production work’. Traditionally, direct labor costs have been restricted to wage-

earning factory workers, but in recent years, with the development of systems for costing

services(‘service costing’), the costs of some salaried staff might also be treated as a direct labor

cost.’ (BPP,p.152)

Production overhead: ‘all indirect material cost, indirect wages and indirect expenses incurred in

the factory from receipt of the order until its completion are included in production (or factory)

overhead.’(BPP, p.154)

‘A direct cost is a cost that can be traced in full to the product, service, or department whose cost

is being determined’ (BPP, p.152)

‘an indirect cost or overhead is a cost that is incurred in the course of making a product,

providing a service or running a department, but which cannot be traced directly and in full to the

product, service or department’ (BPP, p.152)

Direct expense: the cost of special designs, drawings or layouts, the hire of tools or equipment

for a particular job, maintenance costs of tools, jigs, fixtures etc.

‘indirect material which cannot be traced in the finished product, such as consumable stores like

lubricants or minor items of material used in negligible amounts, or amounts which it is

uneconomical to allocate to a particular product, like the cost of glue in box making’(BPP,

p.154)

‘Indirect wages meaning all wages not charged directly to a product, which generally include

salaries and wages of nonproductive personnel in the production department such as foremen,

inspectors, general labourers, maintenance staff, stores staff.

Indirect expenses (other than material and labor) not charged directly to production. The

following expenses could be included under this heading.

Rent , rates and insurance of a factory

Depreciation, fuel, power, repairs and maintenance of plants, machinery and factory buildings.’

(BPP, p.154)

Administration overhead:

‘depreciation of office computer equipment

Office salaries, including salaries of administrative directions, secretaries, accountants

Rents , rates, insurance, lighting, cleaning and hearing of general offices, telephone, internet and

postal charges, bank charges, legal charges, audit fees, depreciation and repairs of office

buildings and machinery.’(BPP, p.155)

Distribution overheads

‘cost of packing cases, materials (eg oil, spare parts) used in the upkeep of delivery vehicles, the

cost reconditioning returned packing cases, ready for reuse

Wages of packers, drivers and dispatch clerks

Freight and insurance charges, rent, rates, insurance and depreciation of warehouses,

depreciation and running expenses of delivery vehicles’ (BPP, p.155)

Costs used for decision making of F05 Ltd:

Cost benefit analysis understand that all people use all the time

There are three problems:

‘ It is often very different to identify the costs that are relevant to a decision.

Some costs cannot be expressed in money terms, for example if you were already very tired, you

could only work overtime at the ‘cost’ of getting more tired, but what it this cost?

Benefits can also be very hard to quantify. A benefit of working overtime might be the

satisfaction of getting the job done, but what is this worth?’ (BPP, p.163)

Relevant cost:

‘Relevant costs are future costs

A depreciation is about the future, it cannot alter what has been done already. A cost that has

been incurred in the past is totally irrelevant to any decision that is being made ‘now’

Costs that have been incurred include not only costs that have already been paid, but also costs

that are the subjects of legally binding contracts, even if payments due under the contract have

not yet been made.(there are known as committed costs)

Relevant costs are cash flows. This means that costs or charges which do not reflect additional

cash spending should be ignored for the purpose of decision making.

A relevant cost is one which arises as direct consequence of a decision. Thus, only costs which

will differ under some or all of the available referred to as incremental costs or differential costs.

Relevant costs are therefore future, incremental cash flows. Relevant costs may also be

expressed as opportunity costs (the benefit forgone by choosing one opportunity instead of the

next best alternative).’ (BPP, p.163)

Non relevant costs:

‘a sunk cost is used to describe the cost of an asset which has already been acquired and which

can continue to serve its present purpose, but which has no significant realizable value and no

income value form any other alternative purpose.’ (BPP, p.164)

Committed costs

‘ a committed costs is a future cash outflow that will be incurred anyway, whatever decision is

taken now about alternative opportunities. Committed costs may exist because of contracts

already into by the organization, which it cannot get out of.’ (BPP, p.164)

Notional costs:

‘A notional cost or imputed cost is a hypothetical accounting cost to reflect something for which

no actual cash expense is incurred.’ (BPP, p.164)

Fixed and variable costs:

Variable costs are relevant costs

Fixed costs are irrelevant costs

Direct and indirect costs depend on situation in question.

Applying scenario of My F05 Ltd:

Direct material cost: direct material (actual result and standard cost)

Direct labor cost: direct labor (actual result and standard cost)

Adm

inistration overheads: depreciation, rent and rates

Distribution overheads: rent and rates

Indirect expense: depreciation, rent and rates

Direct expense: maintenance

a. Accounting Rate of Return( ARR)

Project A: Total income in 5 years = 22,000 + 25,000 + 26,000 + 24,000 + 27,000 = 124,000

Less initial investment : 80,000

Total Net Profit = Revenue – Expense = 124,000 – 80,000=44,000

Average annual profit = 44,000/5=8,800

Total average investment = (80,000+0)/2=40,000.

ARR= (8,800/40,000).100%=22%

Project B: Total income in 5 years= 29,000 + 26,000 + 24,000 + 24,000 + 19,000 = 122,000

Total Net Profit = 122,000 – 80,000=42,000

Average annual profit = 42,000/5=8,400

Total average investment= (80,000+0)/2=40,000

ARR=(8,400/40,000).100%=21%

In this case, Project A is preferred because of higher ARR rate

b. Net present valueAccording to course book we have this formula to calculate NPV

Ct= cash inflows in year t

Co=initial expense

r=cost of capital

In this case r = 15%

Project A

Year Cash Flow Discount Factor Present Value

$ 15%

0 (80,000) 1 (80,000)

1 22,000 0.87 19,140

2 25,000 0.756 18,900

3 26,000 0.658 17,108

4 24,000 0.572 13,728

5 27,000 0,497 13,419

NPV 2,295

Project B

Year Cash Flow Discount Factor Present Value

$ 15%

0 (80,000) 1 (80,000)

1 29,000 0.87 25,230

2 26,000 0.756 19,656

3 24,000 0.658 15,792

4 24,000 0.572 13,728

5 19,000 0,497 9,443

NPV 3,849

NPV compares the value of a dollar today to the value of that same dollar in the future, taking

inflation and returns into account. If the NPV of a prospective project is positive, it should be

accepted. However, if NPV is negative, the project should probably be rejected because cash

flows will also be negative.

For example, if a retail clothing business wants to purchase an existing store, it would first

estimate the future cash flows that store would generate, and then discount those cash flows into

one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell

his business for less than $565,000, the purchasing company would likely accept the offer as it

presents a positive NPV investment. Conversely, if the owner would not sell for less than

$565,000, the purchaser would not buy the store, as the investment would present a negative

NPV at that time and would, therefore, reduce the overall value of the clothing company.

A rate of return measurement can be used to measure virtually any investment vehicle, from real

estate to bonds and stocks to fine art, provided the asset is purchased at one point in time and

then produces cash flow at some time in the future. Financial securities are commonly judged

based on their past rates of return, which can be compared against assets of the same type to

determine which investments are the most attractive.

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