Accounting and Finance

Module MB1 Accounting and Finance
Integrated Graduate Development Scheme
Barry Koch Department of Accounting and Finance Copyright 2003
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ACCOUNTING AND FINANCE
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Contents
Contents Introduction Introduction The course Learning objectives Assessment Study guide Tutorial Days Contact Assignments Assignment 1 Assignment 2 Assignment 3 Section 1- Finance And Financial Management Chapter 1- Long-term decisions Discounting Example 1.1 Example 1.2 The evaluation of projects Example 1.3 What discount factor should be used? A NPV of zero! What about the tax that is paid on the profit generated? What must be included in the evaluation of a project? What must be excluded in the evaluation of a project? Example 1.4 Replacement decisions Other ways of evaluating investments The Internal Rate of Return (IRR) Mutually exclusive projects Example 1.5 Multiple rates of return Example 1.6 The Payback method Example 1.7 The Accounting Rate of Return (ARR) Exercise 1.1 NPV Internal Rate of Return Accounting Rate of Return Conclusion Chapter 2 - Financing a business Types of organisation Sources of Funds Conclusion Past examination questions 3 6 6 6 6 7 7 8 9 10 10 12 15 17 17 17 18 21 23 24 25 27 28 31 35 37 44 45 46 47 48 49 50 51 52 53 55 58 59 60 61 62 63 66 69 70
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CONTENTS
Section 2 - Financial Accounting Section 2 - Financial Accounting Chapter 3 - Basic financial statements Determining the profit of an organisation Example 3.1 Accounting conventions Producing a Balance Sheet Example 3.3 Balance Sheet as at the 31st December Other accounting conventions Example 3.4 Accounting standards Summary Past examination questions Chapter 4 - Published financial statements The Annual Report The Consolidated Cash Flow Statement Notes to the financial statements Basis of accounting Accounting policies Other information in the Notes to the financial statements Limitations of the information contained in the Annual Report Conclusion Past examination questions Chapter 5 - The interpretation of financial reports Applications of ratio analysis Preparing financial statements as part of the budgeting process Conclusion Past examination questions Section 3 - Management Accounting Chapter 6 - Cost Accounting Cost terms and definitions Example 6.1 Example 6.2 Example 6.3 Exercise 6.4 Contribution Example 6.5 Conclusion Chapter 7 - Short-term decisions Break-even analysis Example 7.1 Example 7.2 Example 7.3 Typical examination questions Chapter 8 - Control The goals of the organisation Other approaches to budgeting Measuring performance Example 8.1 Example 8.2
72 72 72 73 74 78 79 81 83 85 87 89 90 91 92 99 101 101 102 103 106 107 108 109 124 125 129 130 135 135 138 141 142 144 146 149 151 154 155 156 158 159 162 169 173 176 180 181 184 188
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Exercise 8.1 Past examination questions Appendix A Appendix B
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INTRODUCTION
Introduction
The course
Although most people have been exposed to some aspects of accounting and finance, this course assumes that you have no prior knowledge of this area of business. In addition, the course was designed to increase your understanding of the topics as users, rather than as preparers of accounting information. The detailed preparation of the information is the task of the book-keepers and accountants. This means that the course will not focus on many of the detailed areas, which are less relevant to managers. However, as recipients of the information, it is important that you understand the nature of the information that is prepared by accountants for both the external or internal users.
Learning objectives
After completing this course, you will: understand the methods used to evaluate investments, particularly projects, which can range from the purchase of new machinery to the acquisition of an existing business or deciding if it is worthwhile to start a new business; be familiar with the nature of the information provided in the financial statements and the techniques used to assess the performance and financial position of organisations; have a knowledge of management accounting which includes aspects of both short-term decision making and control, which is usually achieved through budgets and the budgeting process.
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Assessment
There will be three assignments that will cover the main sections of the course. This will represent 30% of the final mark for the course. The other 70% of the final mark will be the mark obtained in the two hour examination.
Study guide
Each of the sections of the course is independent and cover different aspects of accounting and finance. There is no particular reason to start with the Finance and Financial Management section of the course. However, it is often the first hurdle that must be cleared before a new project commences and so it is the initial decision to be made. External reporting is the main focus of Financial Accounting. This is covered in the second section of the course and this is the information used to assess the overall performance of the undertaking. Finally, the third section of the course, Management Accounting deals with three main areas. These are the provision of information to the management to inform them of the performance within their area of responsibility (scorekeeping), decision making and Control, which is achieved through the preparation of reports that show the areas of that are out of control to enable the managers to take remedial action to eliminate inefficiencies and over-spending. It is possible that you will have encountered some aspects of the course in previously. Most undergraduate programmes recognise that the graduates will function as managers and so aspects of accounting are included. The area of Project Evaluation is commonly included in courses as it is extremely important for managers to understand this area of Finance.
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INTRODUCTION
Tutorial Days
Before the first tutorial day, you should have read the section on Finance and completed the first assignment that will provide you with the opportunity to test your level of understanding of the issues in respect of the evaluation of an investment. First Tutorial Session 1 Session 2 Session 3 Second Tutorial Session 1 Session 2 Session 3 Review of the NPV approach to project evaluation An introduction to Financial Accounting The interpretation of financial statements Review of the second assignment The Annual Report Determining the cost of a product Financial decision making Session 4 Control
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Contact
Barry Koch Department of Accounting and Finance Curran Building 100 Cathedral Street Glasgow G4 0LN Telephone: Fax: 0141 548 3888 0141 548 3156
e-mail barry.koch@strath.ac.uk
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ASSIGNMENTS
Assignments
Assignment 1
The R & D manager of Bantry Limited has designed a product that is expected to capture a significant part of a market. The new product is expected to be a major opportunity to increase the sales of the company over the next three years but it is anticipated that there will be major technological innovations in three years, which will make it necessary to review the entire project. The Sales Director estimates that the sales will be:Year 1 2 3 Units sold 10 000 12 000 15 000 Selling Price per unit 250 300 240
The machinery and equipment will cost 3 000 000 and will only have a scrap value of 1 million at the end of Year 3. The company can write off the machinery and equipment, for tax purposes, at a rate of 20 per cent. Corporation tax is payable at 30 percent and is paid one year in arrears. It will be necessary to increase the stock held by the company by 100 000 at the start of the project. The stocks required will increase by 20% at the beginning of each year but by the end of Year 3, all the stocks will have been used and not replaced. The estimated cost of production is expected to be 120 per unit and there will be additional costs of 300 000 per annum to cover the additional premises that will be rented and the supervisors required to manage the manufacture of the product.
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If the companys cost of capital is estimated at 12 percent, calculate the Net present Value of this project and determine if the company should invest in this new project.
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ASSIGNMENTS
Assignment 2
The Directors of Seapoint plc were shocked at the results that were produced at the first Board meeting at the end of the 2003 financial year end. The performance of the business had been improving for several years and the Directors were keen to increase the dividend declared each year. Although sales had increased and there had been no major change in the companys policies during 2003, the Directors were very disappointed with the preliminary results that were presented to them at the last Board meeting. The summarised results were as follows:Profit and Loss Account Sales - units Year 2001 10 000 000 Sales Cost of Sales Gross profit Administrative and marketing costs Net profit before interest and tax Interest Net profit before tax Tax Net profit Dividends Retained profit 100 52 48 25 23 10 13 5 8 4 4 Year 2002 12 000 000 120 66 54 30 24 10 14 5 9 5 4 Year2003 15 000 000 150 87 63 42 21 13 8 3 5 5 0
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Balance Sheet
Year 2001 000
Year 2002 000 100 30 70
Year 2003 000 100 35 65
Fixed assets (at cost) Less: Accumulated Depreciation
100 25 75
Current assets Stock Debtors Cash 13 22 15 50 Less: Creditors Dividends Tax (18) ( 4) ( 5) 23 Total net current assets Less: Long-term loans 98 44 54 Financed by: Issued share capital Retained profit 40 14 54 40 18 58 40 18 58 18 28 12 58 (22) ( 5) ( 5) 26 96 38 58 26 39 5 70 (26) ( 5) ( 5) 34 99 41 58
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ASSIGNMENTS
Required: 1. Calculate ratios and prepare a report that analyses the possible causes and effects of the decrease in profit and cash during 2003. 2. It is expected that sales in 2004 will increase to 16 000 units at a total of 160,000, the Board recognizes that some urgent actions are needed to bring the company back into a more profitable position. The Administrative and Marketing expenses can be reduced by 7% and the Interest expense will be 12 000. Tax is 35% of the Net profit after interest and Dividends will be 50% of the Net profit after tax. Prepare the expected Profit and Loss account and Balance Sheet at the end of 2004, assuming that the Gross profit and Net profit as a percentage of Sales will be at the 2002 levels. In addition, the managers will also be expected to ensure that the working capital ratios are at the 2002 levels. It is not expected that there will be a change in the Long-term loans during the year. (Hint: The cash balance will be the balancing figure in the Balance Sheet).
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Assignment 3
After the annual budget of Hohenort plc was completed, it was found that the plan did not produce sufficient profit to meet the objectives that had been agreed by the Board of Directors at the beginning of the budgeting process. At a meeting, the heads of each department had a brainstorming session to generate proposals to increase the profitability of the company. The accountant has been asked to assess each of the proposals and produce a report that will assist the Board in reaching a decision regarding the issues that were raised by the managers. The original plan was as Follows:Product Sales units Clifton 1000 000 Sales Variable costs Fixed costs Profit Required:1. Assess each of the following proposals separately to establish if the suggestion 500 300 160 40 Gordon 1500 000 450 330 60 60 Simon 1200 000 480 336 90 54 Victor 1000 000 710 500 140 70 000 2 140 1 466 450 224 TOTAL
will increase the companys profit. (i) Increase the unit selling price by 15% if this will decrease the sales units by 20%. (ii) Improve the quality of the products but this will increase the variable costs by 10%. It is expected that the units sold will increase by 5%.
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ASSIGNMENTS
(iii)
A machine can be hired which will increase the Fixed costs by 100,000 pa. However, the new technology will decrease the Variable costs by 10%.
2.
What is the break-even point of the company if the products will always be sold in
the ratio shown in the budget, namely 10 units of Clifton, 15 units of Gordon, 12 units of Simon and 10 units of Victor? 3. The Production manager dropped a bombshell at the follow-up meeting as she
announced that only 35 000 production hours were available. What products should be produced to maximize the profit of the company? It was possible to out-source the production of all four products and the supplier has quoted the following prices:Clifton Gordon Simon Victor 380 per unit 250 per unit 310 per unit 600 per unit firm to
Should any of these products be purchased from the supplier to enable the new machines?
meet all the demand for its products in the period that is needed to acquire and install
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Section 1- Finance And Financial Management

Chapter 1- Long-term decisions
Discounting is a fundamental aspect of financial management that will be relevant to many of the topics discussed in this course. In particular, it is important in the evaluation of an investment, when an investment today is expected to generate cash flows in the future. By discounting the future inflows, it is possible to determine the present value of all the inflows. By deducting the cash outflow required now, it is possible to decide if an investment is financially sound.
Discounting
Every decision, that involves cash flows over a period of time, must consider the time value of money. The reason is that money today has a greater value than the same amount at a future date. An example will illustrate this statement.
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SECTION 1- FINANCE AND FINANCIAL MANAGEMENT
Example 1.1
A person has 1000 and if it is possible to invest this without risk in government stock at 4% per annum. The value of the deposit will be as follows: At the end of Year 1 At the end of Year 2 At the end of Year 3 1000 x 1.04 1040 x 1.04 1081.6 x 1.04 = 1040 = 1081.6 = 1124.864
Ignoring the tax that is usually payable on interest earned, the value of the original investment will continue to increase at this rate indefinitely. The amount of interest earned increases each year as interest is being earned on the interest from previous years. This is compound interest and from, the above example, it is possible to see that an additional 1.60 was earned in Year 2 on the interest generated in Year 1. Discount tables are available which will speed up the compounding and discounting that is required by many financial decisions. The following assumptions are usually made to simplify the calculations: the cash flows occur at the end of each time period (year), the rate of interest does not change, all the cash flows are certain, there is no inflation so that prices are constant.
From the above example, it is possible to see that the value of 1000 in three years will be 1124.864. Conversely, this means that the sum of 1124.864, received in three years, will have a present value of 1000 today, if the rate of interest throughout the period is 4%.
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The tables, which are included as Appendix A, make it possible to determine both future and present values. This facilitates the calculations greatly and In order to familiarise you with these tables, here are a few problems to tackle.
SAQ 1.1
Using the tables provided, determine the value of 1000 invested today at 4% for 5 years, 10 years and 20 years. 5 years 10 years 20 years 1000 x 1.2167 = 1216.70 1000 x 1.4802 = 1480.20 1000 x 2.1811 = 2181.10
SAQ 1.2
If the rate of interest will always be 4%, for how many years must a sum be invested in order to double the initial investment. From the answer to the last part of the last SAQ, it is clearly less than 20 years. From the 4% tables, it is possible to see that between 17 and 18 years, the factor will be 2.000. In fact, it is about 17.67 years.
SAQ 1.3
If a sum of 3000 is required in five years time, how much should be invested today to have the amount available if the rate of interest will be 4% for the foreseeable future. Using the formula V1 = Vo (1 + r) 3000 = Vo (1.21670) Vo = 3000 / 1,2167 which is 2465.69
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In Appendix A, there are other tables to assist in determining both the future and present value of investments. There are also annuity tables, which provide factors to show either the future or present values if the same amount is either paid out or received at the end of each time period. Thus, the annuity tables will enable the total amount to be calculated if the same amount is invested at the end of each year for the next 5, 10 or 20 years. The present and future value tables of either single sums or annuities cover a wide range of interest rates and time periods. This means that it is easy to establish the following: the present value of an amount received or paid at a future date; the future value of an amount received or paid at a future date; the present value of the same amount received or paid at the end of a given number of years; the future value of the same amount received or paid at the end of a given number of years; Using both the future value of a single investment and the annuity tables, it is possible to determine the expected outcome of many different situations.
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Example 1.2
Using both the single sum and annuity tables, it is possible to calculate the annual amount that must be invested to create a fund that would provide you with the annual cash flow that you consider sufficient for your needs, when retired. If you want to retire when you are fifty years of age, the following steps would be appropriate: 1. Calculate the value of your present savings when you are 50 years old. 2. Decide on the amount that you would need to have accumulated so that the interest generated at 4 per cent per annum will provide an income that is sufficient for you to live comfortably. 3. Use the discount tables to establish the amount which must be invested each year to accumulate the amount. 4. Deduct the amount that was calculated in Step 1 Using the tables provided in Appendix A, it is possible to calculate the amount that must be saved each year to enable you to retire, when you are 50 years old. It is necessary to make some assumptions. These are that the interest rate will be 4% throughout the period and no tax is payable. If you want an annual pension of 24,000, it would be necessary to have 600 000 invested as 4% of this amount would provide an annual sum of 24 000, in a tax-free environment. If you are now 30 years of age, with savings of 10 000, you will see from the future value of a single sum table that this will amount to 21 911 in 20 years, when you wish to retire as the future value factor is 2.1911 for 20 years at 4%. This means that you will need to save an additional 578 089 over the next 20 years to have a total of 600 000 available when you retire. It is now necessary to determine the annual savings required to generate the additional 578 089. From the annuity tables, you will see that the factor for 20
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years is 29.778 If the required amount of 578 089 is divided by 29.778, the answer is 19413.3.This means that the sum of 19413.30 must be saved at the end of the next 20 years. With the interest earned on these sums and the future value of your present savings, the total available at the beginning of Year 21 will amount to the required amount of 600 000. As only the interest generated will be used, this would mean that the 600 000 would be available for your heirs. Of course, if you knew that you would only require a pension for a definite period of time, you could either reduce the amount of the annual saving or increase the amount withdrawn when retired. Thus, if you knew that you would only require 24,000 for 15 years until your occupational pension became payable, the amount that you would to save would be reduced dramatically. The total amount that you would need to accumulate over the next 20 years would be 266 842. (This is the present value of an annual annuity of 24 000 for 15 years. The amount is calculated as 24 000 x 11.1184, which is the present value of an annuity for 15 years. However, your present savings, with a future value of 21 911 will also reduce the total amount be saved over the next 20 years to be 244 931 and this means an annual saving of 244931 / 29.778, which is 8225 per annum is the amount that must be saved to allow you to retire early. There would, however, be nothing available form this fund for your heirs! In practice, you must pay tax on interest received, except for the amounts that can be placed in tax-free accounts, and so the amount actually required would be larger. In addition, the interest rate could change and so affect the final amount. Of course, financial institutions sell annuities but these often are based on the life expectancy of the purchaser and so are not straight-forward calculations of the type described above.
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The evaluation of projects

It is not difficult to see that it would be possible to use the concept of present value to evaluate projects. The estimated cash flows, at the end of each year of the project, will be brought back to their present value and this can then be compared with the actual outlay that is needed to set up the project now. This means that a definite answer can be obtained to judge if the project should be accepted or rejected. In fact, by deducting the present value of the initial outlay, it is possible to determine the net present value of the investment. This will show that the project will: allow the recovery of the funds that have been invested in the project cover any interest costs, and generate a surplus, which is the positive net present value.
It is important to recognise, however, that project appraisal is not an exact science. Most projects are considered over their life and this may be a period of 10 or 20 years. It is usually very difficult to be sure of amount of cash that will be generated over this period and so, although the calculations may be done precisely, it is not always possible to be certain of the ultimate outcome of the investment. However, it is essential that some method be used that takes the time value of money into consideration when making any long-term decision. By means of an extended example, it will be possible to explain the process of evaluating the use of the Discounted Cash Flow (DCF) method of evaluating projects. At each step, additional complications will be introduced to enable you to be aware of the way in which this decision is made in the real world.
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Example 1.3
The Technical Director of a company has been offered a machine that will produce a new product. The Marketing manager believes that the product will be popular and the Accountant must now evaluate the financial viability of this project. The machine will cost 150 000 and it is estimated that this will generate cash flows of 50 000 in Year 1, 70 000 in Year 2 and 80 000 in Year 3. It is expected, however, that a much superior machine will become available after three years and the replacement of this machine would have to be considered. This company uses a discount factor of 10% to evaluate projects of this nature. By taking the timing of each cash flow into consideration, it is possible to decide if this machine should be purchased, although the useful life of the machine is relatively short. It is assumed that the machine will have no value after three years use! 000 Years Estimated cash flows Discount factors (10%) Discounted cash flows 0 (150) 1.000 (150) 1 50 0.909 45.45 2 70 0.826 57.82 3 80 0.751 60.08
The Net Present Value (NPV) of this project is 13,350. This is determined as the sum of the discounted cash flows. The amount of 13 350 is calculated as 45,450 + 57,820 + 60,080 less the initial outlay of 150 000. This is clearly an investment that should be undertaken and despite the short useful life of the machine, the company should purchase it now.
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What discount factor should be used?

The rate at which the cash flows are discounted (10% in the above example) will have a significant impact on the investment decision. To illustrate the effect of a change in the discount rate, if the discount rate in Example 1.3 were increased from 10% to 20%, then the NPV of the project would be reduced to a negative NPV of 13,450. This means that the machine should not be purchased as the NPV is negative and so this project does not meet the required rate of return of 20%. The workings are as follows: 000 Years Estimated cash flows Discount factors (20%) Discounted cash flows 0 (150) 1.000 (150) 1 50 0.833 41.65 2 70 0.694 48.58 3 80 0.579 46.32
The discount rate used that should be used is the companys cost of the capital. It is the Weighted Average Cost of Capital (WACC), which is the average of the companys cost of equity and cost of debt. The weighting being based on the amount of equity and debt used. This means that even if a project will be financed entirely by debt, it is still necessary to use the WACC to evaluate the investment. If only the cost of debt were used and the project showed an NPV that was just positive, it would still not be worthwhile for the company to invest in the project, as the shareholders wealth would not be increased. As a result of the greater risks that shareholders bear, they expect a larger return on their investment. Shareholders expect rates that are higher than those required by lenders. If a company gets into difficulties, the lenders will usually have arranged that they be repaid from the first funds that become available. On the other hand,
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shareholders are always last in the queue. This means that their risk of losing is greater and so the cost of equity is usually considerably higher than the cost of debt. However, a factor that also decreases the cost of debt is that Interest, but not dividends, is recognised as an expense by tax authorities. This means that the interest rate, after tax, is used to determine the cost of capital. If a lender charges interest on a loan at the rate of 5% per annum and the tax rate is 40%, the cost of the debt will be 5% less (40% of 5%), which is 3%. The cost of equity involves the estimation of the level of risk faced by the shareholders. This raises a number of problems and it would not be appropriate to deal with this problem in an introductory course in Finance. Please accept that estimates can be made but it is necessary to make many assumptions that make it difficult to determine accurately. Without doubt, it will be much higher than the cost of debt, especially after the tax effect has been taken into consideration.
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A NPV of zero!
There is, of course, a discount rate that will reduce the NPV to zero and this provides a useful guide to the viability of a project. This is known, as the Internal Rate of Return (IRR) and this appraisal method will be discussed later in this Unit. Knowledge of the IRR is clearly useful information in respect of any investment that is under consideration. In Example 1.3, a discount rate of about 15% would give a zero NPV for the project. This means that if the cost of capital were above 15%, this project would be rejected. However, at discount levels below 15%, this is an investment that should be made, despite the very short useful life of the machine.
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What about the tax that is paid on the profit generated?

Most companies have to pay tax, based on the profit that is calculated in their Profit and Loss account. (We will deal with this financial statement in greater detail in the next section of this course). At the present time, it is sufficient to understand that the P & L account shows all the revenues and costs of the business and if, the revenues are greater than the costs, then the company has made a profit. However, tax must be paid on the profit. This means that in evaluating a project, the first step is to estimate the profit that will be generated as a direct result of the project. All the projected costs and revenues will be included in this statement but one item of expense must be explained. Depreciation represents the cost of using the machine. It is often determined by dividing the original cost of acquiring the machine by the expected useful life of the machine. In our example, the cost is 150 000 and it is expected to have a useful life of 3 years. This means that the Depreciation expense will be 50,000 each year. The profit will be reduced by this amount BUT because this is only an accounting adjustment, NO CASH is paid out. The cash outflow occurs, of course, when the machine is purchased but it would be inappropriate to include all expenditure on new assets as an expense in the year of acquisition. It would result in significantly lower profit in the years, when new assets were purchased and this would give the wrong impression of the firms performance. In addition, the assets are still owned and have a value. For this reason, the cost of using the machine (the depreciation) is spread over its useful life. The implication is that Depreciation must not be included as an expense when determining the cash flows, resulting from an investment. Depreciation is a non-cash expense and will reduce the profit but not the cash flow. It must, therefore, be added back in calculating the cash flow that results from the investment. This can sometimes be the only difference between the annual profit (with depreciation deducted) and the cash flow. Of course, the cash used to purchase the machine at the beginning of the project, must be in the cash flow but it will usually be when the
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discount factor is 1. Generating some figures to fit in with the previous example, the estimated Profit and Loss account would be as follows: 000 Year Sales Cost of manufacturing Depreciation Other expenses 1 500 350 50 100 500 Profit before tax 0 2 600 410 50 120 580 20 3 700 470 50 150 670 30
If tax is payable on profit at a rate of 40%, then the additional tax payable as a result of this investment would be zero in Year 1, 8,000 in Year 2 and 12,000 in Year 3. These payments of tax will represent a real cash outflow but there is usually a delay, as the profit is only determined at the end of each year. This means that the cash outflows in this example will occur in Years 3 and 4. This is important in the DCF calculation, as timing of the cash flows is a vital element of the whole process. Including tax into the evaluation will change the cash flow as follows: -
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000 Years Estimated profit Less: Tax payable 0 1 0 0 0 Add: Non-cash expenses Cash flows from operations Initial outlay Estimated cash flow Discount factors (10%) Discounted cash flows (150) (150) 1.000 (150) 50 70 72 (12) 50 50 2 20 0 20 50 70 3 30 8 22 50 72 12 (12) 0 (12) 4
0.909 0.826 0.751 0.683 45.45 57.82 54.07 (8.20)
The effect of the tax is to reduce the NPV from +13,350 to negative 860 and it changes from being a viable investment into an investment that will reduce the wealth of the companys shareholders.
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What must be included in the evaluation of a project?

From the preceding section of this Unit, you will realise that all the expected cash flows over the life of the project must be included in the evaluation of the investment. These will include the outlays to acquire the assets that will be used and the resulting revenues and costs that will be generated as a result of the investment. It is also necessary to include all the cash outflows that occur, such as the tax payable on the profits generated by the new investment. However, the non-cash items, particularly the depreciation expense, are excluded. There are, however, other items that are relevant and include: -
Working capital
In the example above, the only outlay was the amount spent on acquiring the machine. This was done in Year 0, which is now. The total amount was deducted as that represents the present value of the expenditure. Most projects require that funds be used to cover the additional working capital that will be required. If the company invests in a new machine, then this will result in increase in the stock of raw materials and finished goods. In addition, there are likely to be additional amounts owed by customers or owed to suppliers as a direct result of the new venture. The effect of these changes in working capital must also be taken into the evaluation. However, the working capital will be realised at the end of the project. Thus, there may be an annual outflow as the sales grow but this will only be the incremental amount each year. However, at the end of the useful life of the machine, the project will stop and all the accumulated working capital will become a cash inflow. The effect of the timing of cash flows is the reason that the outflows and inflows, that off-set each other, must be included in the evaluation.
Opportunity cost
It is necessary to include the cash flows that will be foregone if the project goes ahead. For example, the new project may use buildings, which are rented out at the
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WHAT MUST BE INCLUDED IN THE EVALUATION OF A PROJECT?
present time. When evaluating the new project, it is necessary to include the lost rental revenue as a cost of the new project. It is obvious that if large amounts of cash were generated for the organisation by letting the buildings, it would only be sensible to lose these benefits if the new project generated even greater amounts for the firm. This means that the present situation should not be changed unless the benefits of the new project exceed the benefits of the existing situation. It would, however, be necessary to be sure that the present rental contract will continue over the expected life of the project being evaluated, but if this is likely, then it is necessary to include the lost rental revues as an opportunity cost in the evaluation of the new project. However, if there is space available within the area that is currently being rented by the organisation but is surplus to requirements, the rental paid for this space should not be included in the project evaluation. Its opportunity cost is zero as there will be no change in the cash flows whether the new project is accepted or rejected. This assumes that the space cannot be sub-let. The same situation arises if there is excess labour available. If the employees will be paid the same, irrespective of whether the project is approved or not, then no labour cost should be included in the cost of the project, as the opportunity cost is zero. Finally, the amount paid for materials would not be relevant if these materials are already in stock but are considered to be surplus to the current requirements of the firm. If used in the new project, then the opportunity cost would be the scrap value of the material. This is opportunity cost and may, in fact, be zero if they cannot be sold and must be scrapped.
Proceeds of sale of existing machines and their tax implications

If the project is to purchase a new machine to replace an existing machine, then the proceeds of the sale of the old equipment must be taken as a cash flow during Year 0. This is when the cash is received from selling the old machine. In addition, the tax effect of scrapping the old machine must also be taken into account. Thus, if there is a loss on sale of the old machine, it will be recognised by the tax authority as an expense and the amount of tax payable in the next tax year will be reduced to reflect
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this loss or more correctly, the fact that insufficient allowances were made over the life of the old machine to reflect its final decrease in value. In practice, tax authorities do not usually allow the annual depreciation expense to be calculated by means of the straight line method which is calculated as the original cost divided equally over the estimated useful life of the machine. Tax authorities consider that the estimation of useful life is too subjective and could provide a means by which the tax payments could be reduced in its initial years of use. It will not have an effect of the whole life of the asset but remember the Time Value of Money and accountants would prefer to pay less tax now!! This means that tax authorities require another method of determining depreciation. It is usually required that the reducing balance method is used. Tax authorities recommend percentages for each group of assets. This makes it much easier for the tax assessors to judge the amount of depreciation that will be treated as an expense to reduce the profit and consequently, the tax payable in respect of the decrease in the value of the assets. In fact, tax authorities do not even use the term, depreciation, but refer to the amount by which the asset values are reduced, as capital allowances. Thus, on an asset, which cost 10 000 and falls into a category of assets that attracts capital allowances at a rate of 10% per annum, the effect would be as follows: Year 1 2 3 Book Value 10 000 9 000 8 100 Capital Allowance Tax at 30% 1 000 900 810 300 270 243
If the asset were sold at the end of the third year for 5 000, then the book value of the asset would be 10 000 less (1000 + 900 + 810)] = 7 290. However, if the asset were sold for only 5 000, then there would be a loss on sale of 2 290 and the tax in the following year would be reduced by 687, if the tax rate is 30%. In the project evaluation, the 5 000 would be taken in as a cash flow when the
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funds are received and the reduction of tax of 687 would be also incorporated into the calculations.
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What must be excluded in the evaluation of a project?

General overhead costs
The apportionment of overhead costs, such as managerial salaries and the firms general administration and marketing costs, should not be included in the project evaluation. If there will be an increase in the general overheads, especially the administration or marketing costs that can be linked directly to the project, then the increases in these costs should be included. However, if there is no specific increase, a portion of the existing costs should not be included, as the costs will not change if the new project is either accepted or rejected.
Sunk costs
In general terms, only cash flows that are expected to be incurred as a result of the project must be included in the evaluation. This means that expenses that have already been spent or even, already committed, must be excluded. The expenditure that often falls into this category is the design and development expenses that have been agreed previously and possibly, spent to assess the technical viability of the project. These funds will be spent even if the project is rejected and so they are regarded as sunk and should not be taken into consideration.
Interest
Although interest payments involve cash outflows, these should not be included in the determination of the NPV of a project. The interest represents a financing decision and this should be considered as a separate issue. By excluding interest from the investment appraisal, projects that can be funded by existing funds would not be given any advantage over projects that need to be funded by debt. Interest is really recognised in the process of discounting and the inclusion of an interest expense would result in double-counting.
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It seems appropriate at this stage to give you a comprehensive example that will incorporate all the issues that have been discussed. It would be useful if you attempted the evaluation to assess the level of your understanding!
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Example 1.4
Strathclyde Manufacturing Company is considering increasing the output of one of its standard products to meet a new and unexpected order. This order is large in relation to the companys usual business. Over the next four years, 2000 units will be sold each year at a special price of 50 each. The Marketing and Production Directors wish to accept the order, but the Finance Director has some reservations as the profit margin is only 10 per cent of the selling price whereas the companys usual business offers a margin close to 20 per cent. To produce this order, the company must buy a new machine costing 100 000. It is estimated that the machine will be sold at the end of the contract for 30 000. In addition, it will have to use equipment that has been used to manufacture other products, which are not manufactured now. This equipment is fully written off for tax purposes but would have a second hand value of 50 000. There would be no need to invest in new buildings, as space is available in the companys existing factory. An investment of 15 000 in stocks of raw material would be necessary at the start of production. The production costs of the company can be estimated with some confidence as the company has considerable experience in manufacturing this product.
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The Finance Director has provided the following details of the project. Annual revenue 2 000 units @ 50 each Expenses Raw Material Wages Other expenses Share of the overheads (50% of wages) Depreciation straight line over 4 years Annual Profit 30 000 10 000 5 000 5 000 25 000 75 000 25 000 100 000
The company can write off expenditure on machinery and equipment, for tax purposes, at a rate of 25 per cent on a reducing balance. Corporation tax is payable at 35 percent and is paid one year in arrears. The company usually requires a minimum rate of return on investments of this nature of 10 per cent. The Finance Director has been asked to calculate the Net Present Value of the investment. In addition, the assumptions should be made explicit so that these factors could be considered during the negotiation process. The following are the steps that should be taken to decide if this is an investment that is expected to be beneficial to the company. 1. Determine the expected profit that will be generated by the investment. 2. Calculate the tax that will be payable as a result of the change in the firms profit. Estimate the additional cash flows that will be result from the purchase of the new machine. In addition to the information used in determining the expected
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profit to be generated, any extra investment in working capital will need to be taken into consideration. 3. Discount the estimated cash flows, using the appropriate discount rate to be used in assessing this project.
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Step 1 - The expected profit

Tax allowances on new machine at 25% on a reducing balance basis are calculated as follows:Book value of machine Year 1 Year 2 Year 3 Year 4 End Year 4 100 000 75 000 56 250 42 188 31 641 Capital allowance 25 000 18 750 14 062 10 547
000 Year Increased revenue Increase in materials cost Increase in wages Other expenses Overheads Change in profit before depreciation 1 100 ( 30) ( 20) ( ( 5) 0) 45 2 100 ( 30) ( 20) ( ( 5) 0) 45 3 100 ( 30) ( 20) ( ( 5) 0) 45 4 100 ( 30) ( 20) ( ( 5) 0) 45 5 100 ( 30) ( 20) ( ( 5) 0) 45
There will, therefore, be a loss of 1 641 if the machine is sold for 30 000. This loss is recognised by tax authorities as it indicated that insufficient capital allowances were allowed during its useful life.
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Step 2 -The tax payable

Profit after capital allowance Year 1 Year 2 Year 3 Year 4 Year 5 45 000 - 25 000 = 20 000 45 000 - 18 750 = 26 250 45 000 - 14 062 = 30 938 45 000 (10 547 + 1641) = 32812 Tax @ 35% Tax payable 7 000 9 187 10 828 11 484 0 7 000 9 187 10 828 11 484
The tax is payable one year in arrears and that is the reason that the tax liability in Year 1 of 7 000 is paid in Year 2. This will affect the final NPV of the project because of the time value of money!
Step 3 - The cash flows - 000

Year New machinery Existing machinery Increase in stock Change in profit Tax payable Net Cash Flow (165) 0 (100) ( 50) ( 15) 45 0 45 45 ( 7) 38 45 15 45 1 2 3 4 30 5
(9.187) (10.828) (11.484) 35.813 79.172 (11.484)
The machine will be sold at the end of Year 4 and the working capital will also be sold or not replaced at the end of the project, which will result in a cash inflow. It is important to add back the depreciation to the profit. It was 45 000 each year.
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Step 4 - The net present value at 10%

Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 (165 000) 45 000 38 000 35 813 79 172 (11 484) Discount factor @10% 1 0000 0.9091 0.8264 0.7513 0.6830 0.6209 NPV (165 000) 40 909 31 403 26 906 54 074 ( 7 130) (18 838) As the NPV is negative, the machine should not be purchased. The concerns of the Financial Director were justified. However, this project has been evaluated on the basis that:1. The new machine will have a second hand value of 30 000 at the end of year 4 and this will result in a loss of 1 641 when it is sold. 2. The machine that is already owned by the company will last for a further four years and have no value at the end of that time. In addition, the net of tax value of this machine is 50 000 is a fair value of the opportunity cost at the beginning of the project. 3. No working capital, other than the additional stocks, will be needed. 4. The sales of other products that are sold by this company will not be affected by the sale of the new product. 5. There will be no increase on the companys overhead expenses. 6. Costs and selling prices will be constant for the period.
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7. The space used for the manufacture of the new product has no opportunity cost. 8. The rate of corporation tax and the cost of capital (discount rate used) will remain constant.
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Replacement decisions
If there were an existing machine that was being replaced as it had reached the end of its life or a superior machine were now available, then the profit or loss on sale of the old machine would have to be incorporated into the evaluation. The proceeds from the sale of the old machine will be a cash inflow immediately and the next tax payment would usually be adjusted to reflect the difference between the book value and the sale price of the old machine. This was done, in respect of the new machine in the last example. However, with replacement decisions, this process will be done for both the old and the new machines.
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Other ways of evaluating investments

So far in this Unit, only the Discounted Cash Flow method has been discussed. It is the most effective manner of deciding on the investment that is the most financially beneficial project. However, studies have shown that it is the evaluation process that is used least frequently in practice. There is, therefore, a difference between theory and practice and the probable reason is that the other methods are understood more easily and do not require a knowledge of concepts, such as the time value of money or the use of the cost of capital to discount the cash flows. Another important factor is that managers are aware of the great difficulties experienced in forecasting the costs of revenues over the useful life of a machine. They may, therefore, prefer methods that focus on the shortest time until the outlay is recouped. In the preparation of a DCF, it may be necessary to provide forecasts for a period of ten or twenty years, which is extremely subjective and consequently, reduces the reliability of the outcome. The other commonly used methods are: The Internal Rate of Return The Payback method The Accounting rate of Return
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The Internal Rate of Return (IRR)

This method is similar to the Net Present Value method except that the cost of capital is not used to discount the cash flows. This method determines the highest discount rate that can be used and which results in a zero NPV. It is necessary to determine the IRR by trial and error but it soon becomes possible to extrapolate a final result, after a number of different rates have been used to discount the cash flows. The IRR suggests that the project being evaluated would be acceptable, even if the cost of capital increased to the level of the IRR. It can be appreciated that the decision makers, who may lack financial knowledge and experience, would be able to understand this more easily. For example, the members of the Board may feel more comfortable authorising a project that has an IRR of 18% rather having to approve an investment that has a NPV of 500, using a discount rate of 12%. From a theoretical perspective, the use of IRR can sometimes give results that are different to those generated using the NPV method. The areas that can create different results are in situations, where there are mutually exclusive projects or if there are more than one negative outflow during the life of the project. This would, in fact, give two or more IRRs and this could be confusing.
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Mutually exclusive projects

The NPV reflects both the productivity and the amount of the capital used in the project. This is shown by the size of the NPV, which is stated as a value. However, the IRR focuses only on the productivity of the capital. In general terms, an investment should be made in all projects that show an IRR that is above the cost of capital or the rate that is required by the decision makers. However, if it is necessary to select only one project, the smaller investment that has the greater IRR may be selected and this could be the wrong outcome for the organisation. For example, a small project may show a higher IRR but it would be really more beneficial if the larger project, with a lower IRR were undertaken. If they were not mutually exclusive, both should be done. However, if only one is needed, then the NPV will provide the answer. The following example shows this problem clearly.
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Example 1.5
Project Outlay Net Cash Flow at end of Year 1 A B 1000 500 1200 625 20% 25% 90.90 68.30 IRR NPV at 10%
By splitting the larger project into two projects, one being exactly the same as Project B, it is possible to establish that the additional part of Project A consists of an outlay of 500 with a Net Cash Flow of 575. This gives an acceptable rate of return on 15%, which is above the required rate (or the cost of capital) of 10%. In essence, the larger project can do everything that project B does BUT it can also provide another project that is acceptable and so the larger investment should be made.
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Multiple rates of return

If there is more than one outlay, then this can create a situation in which more than one IRR can be calculated. This creates a problem of choice and is, therefore, a weakness of the IRR approach. This problem is not encountered with the NPV method. Mining provides a good example as there may be a second outlay to rectify the damage created by the mining operations. The purchase of the land and equipment would be the first outlay but there would be a large cash outflow again at the end of the project. This means that there are two negative cash flows and two IRRs.
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Example 1.6
The project required an outlay of 1.6 million initially. The cash flows will be The IRR of this project is either 25% or 400%. The figures are:Year 0 Cash Flows At 25% -1.60 1.000 -1.60 Cash Flows At 400% -1.6 1.000 -1.60 Year 1 +10.00 0.800 +8.00 +10.0 0.200 +2.00 Year 2 -10.00 0.640 -6.40 = 0 -10.0 0.040 -0.40 = 0 10
million in Year 1 but an outlay of 10 million would be required at the end of Year 3.
This would present a problem to the person making this decision if only the IRR method is used to evaluate the investment.
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The Payback method

This method of assessing projects focuses entirely on the time that it takes to recoup the initial outlay. The major weakness is that it ignores the time value of money. However, it is very simple to understand and is widely used in practice. However, similar to the IRR method, it does not provide a definite answer as some people may find a payback period of 3 years acceptable but others may want an outcome that is below 2.5 years. The acceptable period could be different for every decision as it is an arbitrary criterion. A simple numerical example will illustrate this method. If a machine can be for 10 000 and it is expected to generate the following cash inflows:Annual cash inflow Cumulative cash inflow Year 1 Year 2 Year 3 Year 4 2000 3000 5000 7000 2 000 5 000 10 000 17 000 bought maker
With an initial outlay of 10 000, the payback period will be 3 years. After three years, the project will have generated 10 000.The problem with this method of assessing projects is that it ignores the time value of money and does not consider the cash flows subsequent to the time that the payback occurs. An example will illustrate these problems:-
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Example 1.7
There are three similar projects and the expected cash flows are:000 Project Cash Outlay Year 1 A B C 9 9 9 Year 2 2 7 7 Cash Inflows Year 3 7 2 2 Year 4 4 4 8 2 years 2 years 2 years Payback period
Each of these projects would give the same result of a payback period of 2 years and so the company would consider them all to be equally good or bad. However, it is clear to see from this simple example that Project B is superior to Project A as more cash is received earlier and the time value of money would always rank Project B as the better of the two projects. Similarly, Project C is the same as Project B except that there is a larger cash inflow in the final year. This is clearly, the best project but this was not reflected in the results given when using the Payback period method to evaluate projects. The wide use of this to evaluate investments is likely as managers are really most interested in recouping the initial outlay. It is also probably affected by the difficulty in estimating the future cash flows of any project.
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The Accounting Rate of Return (ARR)

This method of evaluating investment uses a ratio of the profit to the capital employed. It is a ratio that is often used to assess business performance, especially the past performance of firms and it will be discussed more fully in the accounting section of this course. It is calculated as the average Annual Profit divided by the average Value of Assets used. This means that a project that will generate a cash flow of 500 each year over its useful life of three years, and uses assets valued initially at 1200, will have an ARR of 25%. This is calculated as follows:Profit 500 x 3 = 1500 less total depreciation of 1200 = 300 or 100 per annum Capital used 1200 + 0 = 1200 /3 = 400. This gives an ARR of 100 / 400, which is 25% Alternatively, the annual ARR can be calculated as follows:Average Value of Assets Year 1 Year 2 Year 3 1200 + 800 / 2 = 1000 800 + 400 / 2 = 600 400 + 0 / 2 = 200 Annual profit 100 100 100 Rate of Return 10% 16.67% 50%%
If the Rate of Return were averaged, this would give a simple average of 25.6%. The weaknesses of the ARR method are that it does not take the time value of money into consideration. There can be significant differences in the profit or cash flow generated over the life of a project as it can be relatively low during the start-up period. In addition, the ARR is affected by the assumptions made about the useful life of the machinery, as this changes the annual depreciation charge.
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Despite these weaknesses, the ARR is widely used and great care should be exercised in making decisions on this basis as it is possible that it might give a result, which suggests that the investment is worthwhile, when the reliable method, the NPV approach, would indicate that the project should be rejected. At this stage, it seems appropriate to set an example, which will provide you with an opportunity to test your knowledge of all the methods that are currently used to evaluate projects.
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Exercise 1.1
The Research department of Constantia plc has identified a new product that is expected to meet a temporary demand. However, it is known that major technological developments will occur in about five years and this will mean that new machines will need to be purchased at that time. The machine will cost 900 000 now and this will enable the firm to manufacture and sell the new product. In Year 6, the machine will have a scrap value of 300 000. The depreciation charged is calculated by means of the reducing balance method at a rate of 20% per annum. The accountant has obtained estimates of the sales revenue and costs. The costs do not include the charge for depreciation. The expected profit (in 000s) will be:Year 1 2 3 4 5 Notes 1 2 Tax is payable at a rate of 30% in the following year. If the machine is sold for 300 000 at the end of its useful life, tax of 1 530 would be payable as the net book value would be 294 900 at that stage. 3 In the past, the company has only accepted projects that met the following criteria:a. A payback period of 3.5 years or less Sales 400 420 450 500 520 Costs 100 120 130 150 180 Depreciation 180 144 115.2 92.2 73.7 Profit 120.0 156.0 204.8 257.8 266.3 Tax payable 36.0 46.8 61.4 77.3 79.9
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b. A positive NPV when the cost of capital is 20% c. An IRR of more than 20% d. An accounting rate of return of 20% Required: 4. Evaluate the project using the payback method. 5. Evaluate the project using the NPV method 6. Evaluate the project using the IRR method 7. Evaluate the project using the Accounting Rate of Return and using the straight-line method of calculating depreciation. The first step would be to determine the cash flow each year. This will be needed for both the Payback, IRR and NPV methods. The cash inflows , after the initial outlay of 600 000, are:Sales Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Proceeds of sale of machine Costs Tax 400 420 450 500 520 100 120 130 150 180 Net Cash Flow 0 36 46.8 61.4 77.3 79.9 + 1.5 300 264 273.2 288.6 262.7 (81.4) 300.0 Cumulative 300 564 837.2 1 125.8 1 388.5 1 307.1 1 607.1
The payback reflects the time by which the cash inflows are sufficient to cover the original outlay of 600 000. This will be (900 (300 + 246 + 273.2 + 80.8/288.6)
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which is 3.28 years. This is below the required period of 3.5 years and so the project would be accepted.
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NPV
When the appropriate discount rate has been chosen, the NPV method will provide a definite answer to the question whether the project is financially viable. Year 0 1 2 3 4 5 6 Cash Flow (900) 300 264 273.2 268.6 262.7 218.6 Discount factor @20% 1.000 0.833 0.6844 0.5787 0.4823 0.4019 0.3349 NPV (900.0) 250.0 180.7 158.1 129.6 105.6 73.2 (2.8) Under these expected conditions, the project would be rejected.
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Internal Rate of Return

From the above calculations, it is clear that the IRR will be just below 20 per cent and so the two methods will give the same result. This is the usual situation but there are exceptional circumstances in which the IRR can be less reliable than the NPV approach. In practice, the management would need to consider all the forecasts and estimates that were made in generating the profit and cash flows. Under conditions of uncertainty, it is likely that the managers would decide to reject any project that gave a marginal result of this kind.
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Accounting Rate of Return

This method is based on the average profit generated over the five year period in relation to the average capital used over the same period. The Sales were 2 290 000 and the costs amounted to 680 000. The profit before tax was calculated as 1 610 000 less the cost of the machine which was 600 000 over the period of five years. This gives a before tax profit of 1010 000. The tax at a rate of 30% would be 303 000 and so the after tax profit is 707 000 or 141 400 per annum. The average capital employed was 600 000 and so the ARR is 141 400/600 000*100 which is a return of 23.6%. On the basis of this calculation, it appears that this is an investment that should be made. The problem is that the ARR does not consider the time value of money and this could lead to wrong decisions being taken. In most cases, a number of different methods are used but the NPV method should be given the greatest importance, provided that the correct discount rate has been used!!
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Conclusion
The evaluation of investment opportunities is an important topic in Finance and this Unit provides an introduction to the issues that arise in making the important decision that can have a major decision on the future of an organisation. In essence, the Net present Value approach is the only theoretically sound and foolproof method. The advantages of the NPV approach are that it: takes the time value of money into consideration; includes all the cash flows over the whole life of the project; is directly related to the overall objective of most firms, namely to maximise shareholders wealth; produces the correct ranking of mutually exclusive projects; ranks projects correctly if they have more than one rate of return: allows for differences in discount rates during the life of the project; obeys the value additivity principle, as the net present values of projects are measured in monetary terms and this makes it possible for them to be added together to assess their impact if a number of separate projects must be combined to see the overall outcome of a large project. However, it is an interesting fact that the DCF method is probably the least commonly used method of evaluating projects and tends to be only used by the large organisations, while smaller firms appear to prefer the Payback and Accounting Rate of Return methods. When confronted with decisions of this kind, it is important that you establish the basis on which the proposal has been evaluated as this should be a major element in the decision process.
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CHAPTER 2 - FINANCING A BUSINESS
Chapter 2 - Financing a business

The Introduction and Chapter 1 covered aspects of the way in which businesses are financed. The most important factors that influence this decision are: the type of organisation that is seeking the funds the amount of funding required the length of time that the funds will be needed or what will be done with the finance Essentially, there are two main ways to obtain funds. The first is for the existing owner to contribute additional funds or increase the number of owners of the firm. Alternatively, the additional funds can be borrowed. This might be for a relatively short time if there is only a temporary cash shortage or it could be a long-term loan, which would mean that the repayment of the loan would take place in five, ten or twenty years.
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Types of organisation
The most common forms of organisation are sole proprietorships, partnerships and companies. There are financial implications for each of these forms of ownership.
Sole Proprietorship
The owner contributes all the funds but can obviously also borrow from banks and other financial institutions. This means that the amount available is limited to the amount that the owner is either prepared to invest in the firm or borrow. The availability of loans will be affected by the wealth of the owner, who will be liable for all the debts of the business. This means that if the firm gets into financial difficulties, the owner will be responsible for all the debts. If he or she were very wealthy, the institutions would probably be prepared to lend at relatively low rates of interest. However, if the owner is not wealthy, the banks risk will increase and the rates of interest will be increased to reflect the risk faced by the lender. It is also possible that in this situation, loans may be difficult to obtain. The use of debt can be very beneficial to all businesses. Through gearing, it is possible for the return on investment of the owner to be improved significantly. An example, which ignores tax, will illustrate this: 000 Owners funds Loan- interest at 6% p.a 50 950 1000 Profit before interest and tax Interest payable Profit before tax 157 57 100
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The return (before interest and tax) on the total capital used in the business is 15.7% (157/1000 and the return after the interest at 6% has been paid is reduced to 10% (100/1000). However, the return on the owners relatively small investment of 50 000 is 200% (100/50). This position arises as the owner has invested a relatively small amount of the total capital that is being used. The balance has been borrowed at a cost of 6% but the funds are generating profit at 15.7% before tax and 10% after tax. This situation is not uncommon, and this example illustrates the benefits of gearing. The problem is that this business must make a profit (before interest) of at least 57 000 and if this were not achieved, the business could be in serious difficulties. In fact, the risk of failure is increased by the use of large amounts of debt. This can often be the cause of the high proportion of small firms that fail.
Partnerships
There will be at least two partners, who can supply the capital. As with sole proprietorships, the liability of the owners is unlimited. In fact, as discussed In the Introduction, each partner is joint and severally liable for all the debts of the partnership. This increases the risk faced by each partner, particularly if one partner is known to be wealthy. There will be an agreement regarding the share of the profit that is due to each partner. It is possible that lenders will feel more comfortable with more people responsible for the loans outstanding and so loans may be slightly cheaper and easier to get. Some professions, who handle funds on behalf of the client, can only be partnerships as this gives more protection to their clients. This means that the funding issues are similar to those faced by the owner of a sole proprietorship.
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Companies
The major benefit for a companys shareholders is that their liability is limited to the face value of their shares. As most shares are fully paid-up, this means that shareholders will never be expected to contribute any more funds to bail the company out in difficult times. This creates a problem for anyone, who lends funds to the company or supplies goods and services on credit. Their risk is increased and this often means that the cost of loans may be higher to recompense the lender for the greater risk. In addition, loans may be more difficult to obtain, unless the company has an excellent reputation or it is known that the companys profit is relatively stable.
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Sources of Funds
Issue of new shares
Although the shareholders are not expected to provide additional funds if the company is in financial difficulties, it is quite common for a company to raise additional funds from existing shareholders by means of a rights issue. The existing shareholders can purchase additional shares, usually at a price that is lower than the current market price. This provides a less expensive method of increasing the number of shares issued than an offer to the general public. Public offers incur high legal costs and they are only undertaken if a very large amount of cash is needed. The cost of a rights issue, however, is usually lower and it is likely that the funds will obtained at a lower cost. It is possible for a company to issue Preference shares, which will pay a specified dividend. If the rate specified is 5%, for example, this means that the owner of the preference shares will receive a dividend of 5% of the face value of the preference share each year. The actual rate promised to the preference shareholders will depend on the market conditions at the time of issue. However, depending on the current rate of interest, the price of the preference shares will change. In addition, the holders of these shares will also be preferred in terms of receiving their dividend. This means that even if the companys profit is small, they will receive their dividend before anything is paid to the Ordinary shareholders. Similarly, in the event of the liquidation of the company, they would receive their pay-out before the Ordinary shareholders It is possible to issue cumulative preference shares and this means that if a dividend is not paid this year, double the amount will be paid the following year. . Preference shares are, therefore, similar to debentures, which are issued so that the holders can sell their holdings, which would not be possible if the money had been obtained as a loan to the company.
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Retained profit
Each year, the Directors must decide on the total amount of the profit that will be returned to the shareholders as dividends. This is a decision that will be ratified by the shareholders at the Annual General Meeting. If the shareholders are dissatisfied with the dividend decision, it is possible that new Directors could be elected. It is important to recognise the fact that the markets are interested in the dividend decision as it provides a signal of the opinion of the future prospects of the company. If a smaller dividend is declared, it could be supposed that the Directors believe that funds should be retained to provide a buffer against future problems. On the other hand, the funds may be retained to fund new projects that will increase the wealth of the shareholders. Although it is likely that the nature of the project would not be disclosed, the Directors would reassure the shareholders of the reasons for reducing the dividend. In fact, studies show that Directors usually increase the dividends by a small amount each year. This occurs even when there are big changes in the profit generated. The general feeling is that shareholders like a dividend policy, which suggests a small increase in dividends each year.
Loans
Either short-term or long-term loans can be arranged. The general rule is that shortterm loans should never be used to fund long-term investments. Thus, a typical short-term loan, a bank overdraft, should not be used to finance the purchase of new plant and machinery. It is possible that the bank will suddenly change their mind and recall the overdraft. It may be difficult to obtain the funds immediately if they have been invested in a project that does not have a short payback period. Usually, shortterm loans are used to finance working capital or temporary cash shortfalls although many businesses always have overdrafts and rely on the banks to provide these funds continuously. The advantage of loans over the issue of shares is that the interest is regarded as an expense. This means that the cost of borrowing is reduced by the current tax rate and so this reduces the overall cost of this method of funding. In addition, the benefits of
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gearing that were illustrated at the beginning of this Unit, make this a very common method of financing a business.
Other sources of finance

There are many other methods of raising funds available to firms. These include leases and factoring. Lease financing means that the business obtains the use of a particular asset, without owning it. However, the contract will specify an amount that will be paid annually to the lessor. The type of lease can differ and different legal arrangements can be made to suit both the lessor and the lessee. It is possible for a business to sell their land and buildings to a property company and make a leaseback arrangement. In this way, they receive the cash for their properties and take on an annual commitment to pay for the use of the properties that they formerly, owned. Factoring is a service that is provided by banks and financial institutions acting as factors. As soon as a sale takes place, the firm will be given the full amount of the sale (less the factors charge) and so the firm will not have funds locked up in debtors. This releases the funds immediately to the firm and reduces their working capital and the need to fund this asset in the Balance Sheet.
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Conclusion
If a firm wishes to purchase assets, it is necessary to raise the funds to buy the land, buildings, machinery, equipment and stock. However, by selling to their customers on credit, they are also increasing their assets and so the amount of funding required is a matter that accountants think about continuously. A large new project would clearly make it necessary to consider all the sources available but it is essential that the day to day financial needs of a business is monitored as running out of cash could mean the end of the business if funds are not obtained quickly. The ways and means of financing a business is, therefore, a major issue and will have a fundamental effect on the survival and profitability of all businesses.
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Past examination questions

Question 1
The management of Marline Chemicals plc is considering an investment in a new product. The company expects that it will be necessary to spend 150 000 to develop the product before it can be produced. This development work will be complete before the machines will be operational at the beginning of next year. The equipment will cost 400 000 and will be depreciated for tax purposes, using the straight-line method of depreciation over the expected life of the five years. In Year 6, the machinery will have a residual value of 150 000. The machine will be installed in a building that is not used currently but could be rented to a third-party for 12 000 per annum. It will be necessary for Stock, costing 80 000 to be held in the stores if the new product is manufactured. The sales in the first year of 1 200 000 per annum. It is expected that the sales will increase by 10% per annum in Years 2 and 3 but in Years 4 and 5, the sales will decline by 20% each year. The variable costs will be 20% of the sales value and there will be fixed costs of 300 000 per annum, which will increase by 10% per annum. The required rate of return is 10% and tax of 30 per cent is paid in the following year, Required:(i) (ii) What profit will be generated by this new product? Prepare a net present value analysis to determine if the company should invest in this project. The present value factors are:Year Year Year Year Year Year 1 2 3 4 5 6 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645
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Question 2
A firm is considering purchasing a machine which will cost 100 000 to purchase but will enable them to reduce their operating costs by 35 000 in 1999. However, th savings are expected to increase by 10 per cent per annum as there is an increasing demand for the firms products. The machine will have a limited life of only 5 years and at the end of that time, the scrap value of the machine will be 15 000. The tax payable by the firm is based on 30% of the profit and is paid at the end of the following year i.e. tax on the 1998 profit is paid in 1999. The firm uses a discount rate of 16% for projects of this nature. (a) (b) Should the firm invest in the new machine? Discuss the advantages and disadvantages of the payback method of financial evaluation.
Question 3
The most common methods that are used to evaluate capital expenditure projects are the Payback method, the calculation of the Internal Rate of Return (IRR) and the Discounted Cash Flow method. Explain each of these three methods and indicate the strengths and weaknesses of each approach.
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SECTION 2 - FINANCIAL ACCOUNTING
Section 2 - Financial Accounting Chapter 3 - Basic financial statements

There is always a problem in deciding on the amount of book-keeping to be included in an Accounting course. It is important that you are aware of the process by which transactions are recorded in an organisations records. However, it is much more important that you are familiar with the final products of the recording process rather than the process itself. Essentially, every transaction is recorded in the books twice. This system of double entry means that the two aspects of each transaction are reflected in the records. It is easy to illustrate double entry book-keeping by using a transaction that involves cash. If the transaction is a cash sale, both the cash and the Sales will increase. Alternatively, if the cash is used to purchase an asset, the cash will decrease and the asset, such as stock for resale, will increase by the same amount. When cash is paid out for expenses, such as rent or wages, the cash will decrease and there will be an increase in the amount spent on rent or wages during the year. It is obvious that not every transaction involves an inflow or outflow of cash immediately. Goods, services and assets are acquired on credit. This really only delays the cash outflow until the payment takes place. Fundamentally, it is the same transaction but at the intermediate stage, an amount will be owed to the supplier and this must be included in the accounting records.
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Determining the profit of an organisation

If a business exists for less than one year, the exact profit generated by this organisation can be determined precisely. If all the transactions are completed within the financial year, the profit will be the difference between the cash received and the cash spent during the period. This means that it is not necessary to deal with problems that usually arise. In particular, the value of the remaining fixed and current assets is difficult to determine accurately in order to be included in the Balance Sheet.
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CHAPTER 3 - BASIC FINANCIAL STATEMENTS
Example 3.1
Profit and Loss account for the period ended 31st December 000 Sales cash received Cost of Sales cash paid out for goods purchased Gross profit Expenses cash paid out for services etc. Net profit 1000 400 600 350 250
Most businesses do not exist for less than a year but it can occur if a company is formed to undertake a single project, which is completed within the financial year, Determining the profit generated by this short-lived business is relatively easy as the difference between the cash received and cash spent will represent the profit generated after adjusting for the capital introduced into the business. If the project is completed before the end of the financial year, then all the assets will be sold and therefore, the turned back into cash and so the accountant does not have to be concerned with establishing the value of the asset to include them in the Balance Sheet. In normal circumstances, businesses continue for many years and so it is not possible to sell all the assets of a business at the end of each financial year. This means that estimates have to be made of the values of the remaining partly used assets. The value of fixed assets (land, buildings, equipment and motor vehicles) and current assets (stocks of raw materials and unsold finished goods and the amounts owed by customers) need to be established. In some situations, the valuation is relatively simple and clear but this is not usually the case. To deal with this problem, accountants have developed rules by which these values are determined. It is common to use historical cost, which is easy to identify, but can be misleading as the
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market value may be significantly different. For example, land that was purchased 40 years ago can appear in the Balance Sheet at the price paid at the time of purchase. However, it is likely that the current value is considerably higher. This means that the Balance Sheet shows a value of assets, which is below its current market value. All the transactions need to be recorded in the books of account. This can be a laborious process but computers have reduced much of the drudgery that was once the fate of bookkeepers. Despite the change in technology, the final product of the book-keeping process is still a list of balances. Details of all transactions are in the ledger accounts, which represent the total of each type of asset, liability, expense and revenue. The total of the assets and expenses will be the same as the total of the revenue and liabilities, which includes the amount owed to the owners of the business. This will represent the amount that was invested initially by the owners and all the profit that has been retained within the business since it commenced. This occurs as a result of double entry bookkeeping. If the two totals of the trial balance agree, this indicates that every transaction has been recorded twice and the double entry system has been followed. Each ledger account has a debit and credit side and accountants use these terms to indicate the nature of each expense. However, before starting to prepare the financial statements, accountants make some non-cash entries into the books. The most common adjustment is to reduce the value of assets, especially buildings, machinery, equipment and vehicles to reflect that their value has declined after use for a year. This charge is known as depreciation. It is calculated each year, using agreed rates, and the total depreciation is charged as an expense against the firms profit. The other side of this entry is to reduce the value of each fixed asset. This is an example of a non-cash entry as no cash payment is made. It is also common to increase the expenses to ensure that the profit is never overstated in the financial statements. This is a fundamental approach prudence that is adopted by accountants to ensure that a firms profit is always conservative and never over-stated. After these adjustments have been made, the accountant can use the trial balance to determine the profit.
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Example 3.2
Adam plc was started on 1st July when the shareholders deposited 12 000 into a bank account to start a business. The first transaction was to borrow 30 000 from a bank to purchase business premises. The buildings are expected to be used for 15 years and have no resale value after that period of time. Using the straight line method of calculating depreciation, means that 2 000 per annum (30 000 / 15) will be an expense. Both the profit and the asset will be reduced by 2 000 per annum or 1 000 for the six month period. Over the next six months, the following transactions took place: Goods were purchased for 65 000 but 20% of the purchases have not been sold after six months. 30 000 is still owed to the creditors. Sales were made for 90 000 but the customers have only paid 75 000 to date. However, it is expected that 80% of the outstanding amount will be received eventually. Expenses of 10 000 have been paid and it is estimated that there are unpaid expenses of 5 000 for goods and services which have been received but no charge has been made by the suppliers.
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Based on these transactions, the Profit and Loss account would be: Profit and loss account for the six months ended 31st December 000 000 Sales Cost Sales Gross profit Expenses Depreciation Bad debts Net profit 3 3 21 17 38 15 of 90 52
As it is not possible to record the separate cost of each sale, businesses calculate the total cost of sales by counting and valuing the stock at the beginning and end of the period over which the profit is being determined. The usual method for determining the cost of sales in this case is: Opening stock Purchases Less: Closing stock Cost of Sales 0 65 65 13 52
If products have been stolen or became unsaleable, then the value of the closing stock will be reduced and the Cost of Sales increased. This means that the profit will be lower as a result of the lower value of the closing stock.
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Accounting conventions
In determining the profit, several conventions have been used: the realisation concept recognises that the sales occur when the ownership transfers from the seller to the buyer. This has nothing to do with the payment of cash for the goods as many customers take extended credit periods. The amount owed by customers appears as an asset in the Balance Sheet. (This is one of the problems that appear to have been ignored by the accountants of Enron as the profit from activities was taken into consideration, even though the sales had not really been finalised) in the current Profit and Loss account. prudence requires that a conservative approach is adopted in determining the profit generated over a specific time period. All possible costs and expenses should be included, even if the exact amount owing has not been established by means of an invoice from the supplier. On the other hand, revenues should not be included until it is certain that the profit has been earned. This is concept was taken into consideration in the example as the amount owing by the debtors was reduced as it was estimated that only 80% of the outstanding debtors would pay their accounts. The profit was, therefore, reduced by 3 000 to reflect this possible bad debt. In general terms, accountants are always expected to act in a cautious and prudent manner in establishing the profit of an organisation. This is the first financial statement and the profit figure will be carried forward into the Balance Sheet to ensure that it balances and reflects the amount of profit that has been retained within the business.
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Producing a Balance Sheet

When preparing a Balance Sheet, the starting point is the Trial Balance. This is a list of balances extracted from the ledger, which is the book in which all the entries are recorded. It is usual for the Profit and Loss account to be prepared initially. This results in closing all the revenue and expense accounts in the ledger as the total for the period is transferred to the Profit and Loss account. When this has been done, only the asset and liability accounts will remain in the Trial Balance and these balances will be used to produce the Balance Sheet. It is important to recognise that the profit for the year that was calculated in producing the Profit and Loss account, will be added into the Balance Sheet to reflect the additional amount that is owed to the owners of the business. This profit is added to the Retained Profit from previous years on the other side of the Balance Sheet not the side on which the assets are listed. This will mean that the net effect of all the revenue and expenses items will be included in the Balance Sheet and should ensure that the two sides of the Balance Sheet are equal. This is the final manifestation of the double entry system that is used in all accounting systems. This leads to the accounting equation which states that: Total Assets = Total Liabilities + Ownership Interest Depending on the nature of the funding that is used to finance the business, the Ownership Interest could be either the amount owed to the sole proprietor or the amounts owed to partners in a partnership or the shareholders in a company. It is, therefore, appropriate that the Ownership Interest should appear on the same side of the accounting equation as the amounts owing to creditors and lenders. Using the figures from the ledger means that the value of the assets in the Balance Sheet will be the amounts that were paid for the assets when they were acquired. Clearly, it is possible to adjust the values and it is not unusual to re-value assets. There are a number of accounting conventions that have developed. The two conventions that are particularly significant in determining the value of the assets are historic cost and prudence.
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The fixed assets are usually shown in the Balance Sheet at the amount that was paid for the land, buildings, machinery, equipment or motor vehicles. This provides a figure, which can be confirmed by the documents produced at the time of purchase. However, it is usual for the value of fixed assets to be subject to depreciation, which was explained earlier in this Unit. However land is an exception, as it is not usually depreciated. Readers of British or American financial statements may also find that assets, especially land and buildings are often revalued. There is no prescribed way of determining the amount by which the asset values are increased and the revaluation can be done whenever the management thinks it is advisable to show more realistic asset vales in the Balance sheet. In a Balance Sheet, it is possible to see the amount by which the asset values have been increased as the Revaluation Reserve is always shown as a separate figure in the Balance Sheet, usually under the Share Capital and Retained earnings figures. It is important to recognise that the Balance Sheet represents the financial position of the company at a specific time, usually at the end of the day at the end of the firms financial year. A Balance Sheet has been compared to a photograph as it shows the state of the company at a moment in time. The Profit and Loss account, on the other hand, is a summary of the transactions involving revenues and expenses for a longer period of time. Although it is unlikely, every figure in the Balance Sheet could change on the first day of the new financial year. This would imply that fixed assets were purchased, cash received and credit received from suppliers for goods received or services used. It is important to recognise that each time a transaction occurs, the Balance Sheet changes.
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Example 3.3 December
Balance
Sheet
as
at
the
31st
000 Fixed Assets (at cost) Less: Accumulated Depreciation Current Assets Stock Debtors Cash (12 30 + 30 - 35 +75 10) Less:Creditors Less: Long-term loans 29 Share Capital Retained profit 13 12 42 67 35 32 30
000 30 3
000 27
2 12 17 29
If the shares of the company are traded on a stock exchange, it is possible to determine the market capitalisation of a company by applying the current share price to the number of shares issued. After adjusting for debt, the value of the assets can be ascertained and compared to the balance sheet value. The share price usually leads to an asset value that is three or four times higher than the values shown in the Balance Sheet. This results from the use of the rules, especially the use of historic cost to value the fixed assets. If the Balance Sheet is seen as the means by which interested parties are informed of how the funds, obtained from shareholders and lenders, have been used to acquire Fixed and Current Assets. Service companies, such as advertising agencies, employment agencies and
management consultancies, are examples of firms in which there is a significant
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difference between the Balance Sheet value and market value of a company. It is possible that service companies may not have any fixed assets and relatively small amounts owned or owing in the forms of debtors, cash and creditors. However, if the company is successful, its value could be extremely high. There would, therefore, be a very large difference between the market and book values of the company.
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Other accounting conventions

Now that you are familiar with a Balance Sheet, you need to be aware of the other conventions used in its preparation, which include: -
Money measurement
Only assets that have been purchased are shown in the Balance Sheet and so the value of the staff is not reflected in the financial reports. The brand name of the products usually falls into this same category but some UK companies now value their brands and show them as an Intangible Asset in the Balance Sheet. As this is clearly inflates the value of the assets, this has caused concern in the accountancy profession.
Going concern
In terms of the prudence conventions, it is necessary to show assets in the Balance Sheet at the lower of cost or the value that would be obtained if they were sold in the open market. If the asset does not have any other uses, the demand for it might be low and consequently, the value may be below the historic cost. In this situation, the value in the Balance Sheet should be reduced and this would result in a reduction in the profit being reported. To prevent this problem, it is convenient to assume that the business will continue indefinitely, so that cost less depreciation can be used to determine the value of the assets. The going concern convention enables this to be done.
Business entity
The assets and liabilities of the business are kept totally separate from those of the owners. This is not usually a problem with companies but in sole proprietorships, there can be confusion between the business and the owner. For example, company cars are registered in the name of the company but in the case of a sole proprietor,
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the position may not be so clear. The purpose of this convention is to determine whether assets should be shown in the Balance Sheet of the business or owner.
Materiality
Small assets, such as office stationery or petrol in the company cars, should not be included in the Balance Sheer as an asset. They are usually to be treated as an expense on purchase. In fact, most British companies state their financial statements to the nearest million.
Consistency
To enable the companys financial statements to be comparable over a number of years, the accounting policies are kept the same. If it is decided to change an accounting policy, this is shown clearly in the section that deals with Accounting Policies and the effect of the change may even be highlighted in the Annual Report.
Accounting period
Although British companies are required by law to produce financial statements
annually, the management can choose the dates of the financial year-end. Although many companies have adopted the calendar year, others have chosen 1 st April as the beginning of their financial year. The other conventions, realisation, matching and prudence, which were discussed earlier in the Unit, are not particularly relevant to the Balance Sheet. However, they are part of the basic framework used to guide accountants in the preparation of financial statements. At this stage, it is appropriate to summarise the process from a Trial Balance to the preparation of the financial statements.
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Example 3.4
The trial balance of a service company that trades as a sole proprietorship was extracted from the books of account, after all the adjustments had been made. The balances in each account, at the end of the financial year, were:The first step would be to decide which items will appear in the Profit and Loss account. These will be the Revenue and Expense items and the profit will be the difference between these. Profit and Loss account for the year Income / Sales Expenses Net profit 1000 350 650
In the real world, it is usual to give more details of the nature of the expenses. The other items in the Trial Balance will be either Assets or Liabilities. The Owners investment can be regarded as the amount owing to the Owner by the business.
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Balance Sheet at the end of the year 000 Fixed Assets Land Buildings at cost Less: Accumulated Depreciation Equipment at cost Less: Accumulated Depreciation Current Assets Debtors Cash at Bank 520 Less: Creditors Less: Long-term loan Owners investment Add: Profit for the year 360 160 90 70 770 120 650 770 500 20 210 10 500 30 470 700 200 30 000 000
There is no tax reflected in these simple financial statements but if tax were payable, the profit would be reduced and there would be another liability in the Balance Sheet to reflect the amount owed to the Government.
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Accounting standards
In the 1970s, US and UK accountants became interested in developing accounting standards. The objective was to achieve a greater degree of consistency and uniformity in the published financial statements within each country. It has been suggested that an ulterior motive was to provide a better basis of defending their position, as most accounting firms were subjected to accusations of criminal negligence in terms of the reports that were provided to the shareholders. As most of the multinational audit firms have been found guilty of negligence, it was a sensible strategy for the firms to encourage the publication of standards which would act as guidelines in the preparation of the financial statements. The International Accounting Standards Committee (IASC) was formed with the objective of achieving a greater degree of uniformity and comparability in the financial statements that are published. Initially, the Committee was forced to deal with major problems as there were fundamental differences between the financial practices in the US and UK, France, Germany and Japan. However, over the years, the IASC has produced a number of standards, which have affected the way in which the financial reports are presented. In addition, the European Union has also been tackling this problem and all EU countries are expected to adopt the accounting policies that are detailed in the Fourth and Seventh Directives. This has resulted in more drastic changes in countries such as France and Germany as many British concepts have been incorporated into the directives. For example, true and fair was included in the Fourth Directive but as this concept is virtually impossible to define precisely, there was considerable discussion in France, Germany and Greece. Accountants in these countries were used to a tax based system, which specified the precise treatment of many accounting transactions. This means that the judgement of the professional accountants was subservient to the strict observance of the accounting rules in the legislation. The changes introduced by the EU directives have changed this approach to accounting. The development of national and international accounting standards has meant that there is now a greater degree of uniformity in the financial reports that are published.
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This is particularly noticeable in France but it likely that the need to raise funds in the international capital markets has had a much more significant effect on accounting policies that the EU directives or the International Accounting standards. Although all the accounting standard-setting bodies have been working to achieve Statement Analysis more comparable financial statements, there are still significant international differences in the accounting practices of most countries. Accounting practices have developed over the years and there are significant differences in the manner in which the financial regulation is implemented in each country. In Germany and Japan, legislation has been passed which prescribes the ways in which different aspects of accounting are reflected in the financial statements. In the UK and US, the organisations accountants and the external auditors agree on the accounting rules that are used and this arrangement is reflected in the audit report which states that the accounts reflect a true and fair view of the state of the company. This concept has been used in the UK and US for many years but has now been adopted in the EU directives. Although this has meant that there is a greater degree of conformity within the EU, there are still very distinctive differences in most countries. It is not surprising that countries, which have strong historical links to Britain, such as India and Australia, have accounting systems, which have many similarities to the British system. It is essential that readers of financial statements appreciate the rules that have been used in the preparation of the reports. This is a topic that will explored in greater depth in the course, Financial, which you will study in the second semester.
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Summary
This unit has tackled the preparation of a simple profit and loss account and balance sheet. Issues included are accounting conventions and some of the steps taken to achieve a greater degree of uniformity and comparability. The formation of the IASC was also mentioned in order to make you aware of the different legislation, accounting standards and accounting practices in every country. This unit will serve as an introduction to the next unit, which will deal with the financial reports that are published by all large companies that are quoted on a Stock Exchange.
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Question 1
(a) Explain FOUR of the accounting conventions which are used in the preparation of financial statements. (b) Discuss the information in the financial statements which will be of greatest interest to:(i) (ii) (iii) existing shareholders; lenders and suppliers employees
Question 2
(a) Explain the following accounting conventions and discuss the effect on the value of the assets in the Balance Sheet of a company that adopt them. (b) The second part of the question required a discussion of the information provided in a Cash Flow statement and its usefulness to readers of the Annual Report. This will be covered in the next chapter.
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Chapter 4 - Published financial statements

It is important that managers are able to understand the Annual Report that is published by companies, as this is the main way in which public companies communicate with their shareholders. Although there are differences in the accounting practices used in every country, the similarities are often greater than differences. As a result of the EU policy of harmonisation, directives have been published which have resulted in a greater degree of uniformity in the financial reports of companies that are based within Europe. The format of the financial statements and the accounting policies used are not uniform but there is now a greater similarity between the reports published in the UK, France, Germany, Greece, Italy and Spain. In addition, the financial reports produced by companies in most British Commonwealth countries are based on the British approach to financial reporting. In the UK, it is traditional to disclose more information than is required by the regulatory framework. The 2002 annual report of Marks and Spencer plc (M & S) will be used to show a typical UK companies report. A copy of the most important reports is included in Appendix A. (A full copy of the most recent report can be obtained from the M & Ss website)
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CHAPTER 4 - PUBLISHED FINANCIAL STATEMENTS
The Annual Report

Marks and Spencer plc publishes and Annual Report that include: -
The Chairmans message

This is a letter to the shareholders from the Chairman. There is no legal requirement that there should be a message of this nature but most Chairmen use the publication of the Annual Report as an opportunity to inform the shareholders of any good news. It also means that any difficulties can be explained with an indication of the steps that have been taken to improve the situation. In 2002, the Chairman of M & S was able to discuss the success of the strategy that he had initiated. During the year, the managers had focussed on the heart of the business and any non-core or loss-making activities had been discontinued. In addition, the capital structure of the company had been adjusted by returning 2 billion to the shareholders by means of an issue of B shares, which have either been redeemed by the company or will be redeemed in the future. At the same time, the companys long-term debt increased by 2156.3 million. This would reduce the weighted average cost of capital. The Chairman stated that by having the right team and listening to their customers, the management had focussed on the most important issues to improve the position of the company. In the previous Annual Report, the Chairman suggested that the previous Board had allowed itself to be distracted from its fundamental strengths and values. The Chairman was clearly pleased to report that the sales of the continuing operations had increased by 3.8% and that the M & S share was considered to be the best performing share in the FTSE 100.
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Financial review
This is another voluntary report that enables the management to focus on any aspects of the performance and financial position of the company. In the M & S report, a summary of the results is provided and the increases in Sales (3.8%) and Profit before Tax and Exceptional Items (30.7%) were highlighted. This is the message that the Board would like to communicate to the shareholders and it is likely that even casual readers will read this part of the Annual Report. Segmental information is included to provide the readers with information about the performance of the different sectors of the business. This could be used as a basis on which to predict the future earnings of the company. The Financial Review also provides information about some of the decisions that have been made during the year. Details of discontinued operations, dividends, changes in the Capital Structure of the company, the Treasury policy and financial risk management are given to enable the readers to be aware of these aspects of the business, particularly during the year to March 2002. Finally, a statement is made about the outlook for 2002/03. This predicts that the clothing profit margins will improve but food sales will fall. It is stated that costs will increase for a number of reasons but no forecast of the overall effect on the total profit is provided. This would not usually be included, as it would provide easy target for critics at the next Annual General Meeting if the performance did not meet the forecasted level. As there is strong competition in this industry, it would not be wise to publish a forecast of the level of profitability at this stage.
Other reviews
These are reviews of other aspects of the company. These include: A report on Corporate Governance, which gives details of the Board members, the relations with shareholders and outlines the companys policies in respect of risk assessment, internal control and assurance.
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The Remuneration report focuses on the amounts paid as salaries and bonuses to the Directors. In addition, details of the Executive Share Option schemes are provided. This report ensures that the remuneration policy is open and transparent. Over the past few years, there has been considerable discussion in the media of the phenomena of fat cats. The remuneration paid to some Directors were exposed if they considered to be excessive, particularly if the company was not performing well.
The management of M & S devote a considerable amount of the Annual Report to these voluntary reports. This is not uncommon with companies that sell consumer products. However, varying amounts of this additional information are disclosed and there are often significant differences in the content of these reviews.
Directors report
In the UK, the content of this report is prescribed by law. This information can, therefore, be considered to be the minimum information that should be disclosed to shareholders and financial analysts. As it is a legal requirement, most company reports provide similar information. The Directors Report of M & S gives details of the principal activities of the company, a statement of the companys profit and details of any changes in the Share Capital and the Board of Directors. There is also a statement to publicise that the company has policies, which do not discrimination on the basis of gender, colour, ethnic or national origin, disability, age, marital status, sexual orientation or religion. Finally, readers are informed of the companys policies relating to the payment of creditors and the amount of the donations to charitable and political organisations.
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Audit report
In order to provide confidence to the readers of the Annual Report, there is a legal requirement that an independent firm of accountants certifies that the financial reports present a true and fair view of the company. It is important to recognise that only the sections of the Annual Report that specified in the Audit Report have been audited. The voluntary sections are never covered by the Audit Report but the Directors report would have been scrutinised by the auditors. The concept of true and fair is not precisely defined but has been used in the UK for many years. It was adopted in the European Unions Fourth Directive. This means that it can be assumed that the financial reports of all EU companies show a true and fair picture. However, the particular accounting practices within each country will be evident in the financial reports that are published. In order to provide this certification, auditors make continuous checks on the systems to ensure that the business is carried on in an appropriate manner. In addition, the Auditors verify that the values placed on assets and liabilities in the Balance sheet and verify that the assets exist and have been valued in an appropriate manner.
The accounting statements (Appendix B)

There are three main financial statements that make up the accounting reports in most Annual Reports. These are the Balance Sheet, which shows what is owned and owed by the company. the Profit and Loss account, which shows the difference between the revenues and expenses, and the Cash Flow statement, which shows the inflows and outflows of cash that have occurred over the period. It is necessary for companies, such as M & S, to produce a Group Balance Sheet. If a company owns all the shares in another company, then the assets and liabilities of
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the subsidiary will be included in the Group Balance Sheet. Similarly, If the company only owns a portion of the shares, it will include all the assets and liabilities in the Group Balance Sheet if it is known that it owns sufficient shares to control the subsidiary. Control is held if more than 50% of the voting shares are owned but in some circumstances, the Holding Company can control the subsidiary even though it owns less than 50% of the voting power. In the Group Balance Sheet, the portion that is owned by the third parties must be shown as Minority Interest, which is considered to be a liability. In the M & S Balance Sheet, this was 15.6 million in 2001 but has decreased to only 0.4 million in 2002. This reflects the sale of many of the subsidiaries, which were making losses, during the year. The profit belonging to the other shareholders is treated in the same way and Minority interests are also shown in the Consolidated Profit and Loss Account. In the M & S accounts, this is a loss in the current year, which results from the poor performance of the subsidiaries, most of which are now classified as Discontinued Operations.
The Consolidated Profit and Loss account

Although there is a considerable amount of detail shown in the M & S Profit and Loss account, it is essentially the same information that is provided in the basic Profit and Loss account shown in the previous unit. The format is also similar. The M & S Profit and Loss account shows the Turnover, Gross profit, Operating profit and the Profit before Tax and the Profit after Tax for the year to the 31 March 2002. There is an adjustment to reflect the Minority interests and finally, the dividends are deducted to show the Retained profit (or loss) that will be transferred to the Balance Sheet. The previous years figures are presented in the same form to enable readers to compare the figures for the two years. M & S had two bad years. The 2002 profit after tax was 153.4 million compared to only 4.0 million in 2001. This figure was much below the 2000 figure. This is the good news that was discussed in the Chairmans report.
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The Consolidated Balance Sheet

A Group Balance Sheet and a Company Balance Sheet are produced for 2001 and 2000. The Group Balance Sheet will include the assets and liabilities of both the Company and all the subsidiaries, which it controls. The Accounting policies state that the accounts are presented using historical cost but the fixed assets had been re-valued in 1988. This means that at the end of 1988, the assets would have reflected the values placed on them by an expert. From the revaluation reserve, which is shown in the Capital and Reserves section of the Balance Sheet, the value of the assets, which are still owned by the company, have been revalued by 455.6 million. At 31 March 2002 Balance Sheet shows the following: million Fixed assets Investments Net current assets 3381.2 50.3 2009.9 5441.4 Note: The Current Liabilities are usually deducted from the Current Assets in most UK Balance Sheets to show the Net Current Assets. This means that the total resources that are being used by this company are 5441.4 million.
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The Net Assets are funded either by Debt or Equity and it is customary to deduct the Total Debt from the Assets in a British Balance Sheet. The Long-term Debt is 2156.3 million and the provisions are 208.3 million. This totals 2360.0 million and when this is deducted from the Total Assets less Current Liabilities results in Net Assets of 3081.3 million. The equity funding has been obtained from the following sources: Million Issued Shares Share premium Reserves 852.7 2.8 2225 4 3080.9 Minority Interests 0.4 3081.3
From the Balance Sheet, it is possible to see the amount that has been invested in the different assets. However, it should not be assumed that the company is worth 3081.3 million. The use of historical cost will usually understate the value of the company. At the end of 2001, the shares of M & S were selling for 3 per share and as there were 2,867,383,731 issues, therefore, the market capitalisation of the company was 8 602 million, which is more than double the book value of the assets.
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The Consolidated Cash Flow Statement

This financial statement focuses on the inflows and outflows of cash from the company. The cash flow is a very important issue. The survival of the business depends on the availability of either cash or debt facilities. It is likely that the cash outflow will be negative if the business is spending funds on expansion programmes but this is a situation that should not persist year after year. Negative cash flows increase the possibility of the business getting into a difficult position and banks are often reluctant to lend to businesses, which experience a cash crisis regularly. In 2001, M & Ss cash increased by only 13.5 million. However, in 2002, there was an increase of 1132.0, which can be attributed to the sale of the loss-making subsidiaries. The cash flow can be controlled to some degree by means of the discretionary payments. Dividends, for example, can be reduced if the company is expecting to show cash deficit for the year. The reduced dividend payments may result in adverse comments regarding the companys management or reduce the share price if the lower dividend were seen as a sign of weakness in the company. Alternatively, capital expenditure on new assets may be curtailed, which could reduce future growth. In the M & S cash flow statement, it is clear that dividends were reduced in 2001 to 258.6 million. This is lower than the 2000 dividend, which totalled 413.5 million. In both 2001 and 2002, the acquisitions were 269.8 and 285.7 respectively. This was about the amount of the depreciation charge in each year. This means that the managers were really only re-investing the amount that had been written off as depreciation.
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The format that is commonly used in the UK divides the cash flows into the following sections. By using the M & S figures for the two years, it provides an opportunity to see the usefulness of the cash flow statement in predicting the future cash flow of a company 2002 million Cash flow from operating activities Cash flow from investing activities Taxation paid *Capital expenditure *Acquisitions and disposals *Equity dividends paid Cash inflow / (outflow) 1093.7 36.8 (179.4) 176.0 261.6 (256.7) 1132.0 2001 million 676.4 12.6 (164.6) (258.2) 5.9 (258.6) 13.5 the
The last three items which are marked *, can be varied at the discretion of for the Directors to reduce these cash flows.
Directors. This means that if there is likely to be a negative cash flow, it is possible
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Notes to the financial statements

This is the part of the Annual Report that provides readers with the details. It has been suggested that a set of financial statements should be read backwards. This implies that the Notes to the Accounts should be the starting place to ensure that any reader will get a complete picture of the company. Against most items in the financial statements, there are references to the Notes. The basic approach is that the amount of detailed information shown in the actual financial statements is kept to a minimum and the details are placed in the Notes to the Accounts. In the 2002 Annual Report, the Basis of Accounting and the Accounting policies have been included under the broad heading of the Notes to the financial statements.
Basis of accounting
During 2002, there was no fundamental change in the basis of accounting. There was a change in the financing structure of M & S as the equity was reduced and debt increased but the basis of accounting did not change.
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Accounting policies
This part of the Notes provides details of the specific choices that the company has made regarding the accounting rules that are used in the preparation of the Annual Report. The management of every company can choose the accounting policies that are considered to be the most appropriate for their circumstances. To achieve consistency, these policies do not usually change from year to year but it is important that this part of the Annual Report is studied by anybody that wished to compare the performance and financial position of M & S with any other company. M & S use the historical cost method of accounting but readers of the Notes are informed that the fixed assets were revalued. It would be surprising if any other basis of accounting was being used in a UK company. Some of the other accounting policies, which are identified in the Notes, are the manner in which Turnover is determined, the basis of valuing current asset investments, the basis of valuation of fixed assets including depreciation rates used and the accounting methods adopted in respect of operating leases, derivative financial instruments, foreign currencies, goodwill and pension contributions.
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Other information in the Notes to the financial statements

Additional information on a range of different matters is included in the M & S Notes. It is intended that this information will assist readers to understand the nature of the business more fully and possibly, to predict future performance more accurately. Some of the information provided Includes: -
Segmental information by class of business and geographical basis

Turnover, Operating profit and Operating assets are analysed into the two main activities of M & S, namely Retailing and Financial Services.
Operating costs
Details are provided of employee costs, occupancy costs, repairs, renewals and maintenance costs, depreciation, audit fees and non-audit fees paid to PricewaterhouseCoopers, who are their auditors. The Companies Act specifies that some of this information must be provided but this company provides more than the required minimum.
Exceptional items
In this report, details are provided of Restructuring costs, the Profit or Loss on the sale of property and other fixed assets and the amount of Interest earned and paid. Finally, the amount of the provision made for any losses on operations, which are to be discontinued or sold, is shown.
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Earnings per share (EPS)

Companies are required to calculate the EPS figure and show it as a note to the Profit and Loss account. This enables readers of the report to assess the earnings of the company but there are difficulties as a company could issue either one million shares of 1 each or 4 million shares of 25 pence each. This would raise the same amount but would clearly affect the EPS. An important use of the EPS is that it is used to calculate the Price Earnings ratio that relates the EPS to the share price. The P/E ratio is widely used to measure the confidence of the share markets in a company. The P/E ratio reflects the price that investors are prepared to pay to acquire a share in the company and the share price is related to the current earnings of the company
Employees
The average number of employees and the amounts paid to them both directly and indirectly. The indirect payments include social security costs, pension costs and employee welfare costs. An Accounting Standard, dealing with Pensions, has been adopted recently and the specified information is included in the Notes. Details of the Executive Share Option schemes, Directors emoluments and Transactions with Directors are also disclosed. Other areas that are covered in the Notes are: the cost and accumulated depreciation of the Tangible Fixed Assets; Fixed Assets Investments including details of the subsidiaries; Debtors, both short and long-term; Current asset investments both listed and unlisted; Cash at bank and in hand; An analysis of the financial assets in Sterling, US dollars, Euro and Other currencies after taking the effect of the interest rate swaps into consideration;
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Creditors, both short and long-term and the maturity dates of all financial liabilities;
Details of the companys financial instruments and risk management policy; The authorised and allotted, called up and fully paid share capital; Details of the transactions that have affected shareholders funds during the year;
An analysis of the cash flows given in the cash flow statement Details of the effect of the sale or closure of operations; An analysis of the companys net debt; Commitments and all contingent liabilities;
The foreign exchange rates used in translating foreign assets in the financial statements. The accounting policies are the starting point for financial analysts who wish to compare the performance and financial position of M & S with any other company in any country. Even within the UK, it would be possible for another company to adopt different accounting policies. The effect of these policies would have to be taken into consideration if the two companies were being compared. For example, M & S depreciate their fixtures, fittings and equipment over a period of 3 to 15 years, according to the estimated life of the asset. However, another company may choose to estimate a much longer useful life of their assets. This would mean that their annual depreciation charge would be relatively lower and their profit might, therefore, appear to be higher than that of M & S.
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Limitations of the information contained in the Annual Report

In Unit 1, the users of financial information and their needs were discussed. After explaining the nature of the information that is included in an Annual Report, it is appropriate to review this issue. The problems that are usually encountered by non-accountants who try to analyse the information that is published by companies. Some of the difficulties that arise are: the use of jargon as the terms used are often not defined precisely: the diversity of accounting policies that are used and this is a particular problem in countries in which accountants have a greater degree of discretion in the choice of accounting policies; the Annual Report usually takes at least four months to be published and this means that the value of the information is diminished by this delay. the use of historical cost as this ignores the current market value of the assets.
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Conclusion
The financial statements of Marks and Spencer plc provide a good example of the Annual Report produced by a UK company. It is important to recognise that the report of every company will be different. The M & S format is more comprehensive than many of the Annual Reports that are published each year. It should be recognised, however, that studies have shown that most shareholders do not spend much time reading the Annual Reports. This may reflect that the users recognise the limitations of the information that is provided in an Annual Report. Despite the limitations, the Annual Report is the most important source of information available and it provides a summary of the performance of the company over the past financial year. In addition, the Balance Sheet shows the financial position of the company at a particular moment in time. It is, therefore, a valuable source of information to anybody, who is trying to make decisions about the viability and future performance of a company.
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1. (a) Identify four different users groups that will be interested in the
information in a public companys Annual Report. (b) Discuss the information in the Annual Report that will be of particular
interest to each of the groups that you identified in (a). (c) 2. Discuss the Auditors Report and its usefulness to shareholders.
Discuss the information provided in a Cash Flow statement and critically assess its usefulness to readers of the Annual Report.
(The other part of the question was included in the previous chapter)
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Chapter 5 - The interpretation of financial reports

Earlier in this Section, the nature of the information shown in a Profit and Loss account, Balance Sheet and Cash Flow statement was discussed. The financial reports of Marks and Spencer plc were used to illustrate the type of information that is published by many companies to keep their shareholders informed. However, as the Annual Report is published, it can be obtained and analysed by anybody who is interested in the past performance and financial position of the company. We will look now at the techniques that are used to interpret the information that is usually available in the financial statements. The best starting point is to consider interpreting the financial statements of a single company over a number of years. This will enable the trends in profitability and liquidity to be determined. In addition, you should obtain a good idea of the manner in which the working capital is being managed and the decisions that have been made about the capital structure of the business. In particular, the amount of debt that is being used is very important as this affects the financial risk profile of the business. Finally, the investment ratios can be calculated for companies that are quoted on a stock exchange. A more difficult task is to compare the performance and financial position of two or more firms. The problem is that it is necessary to consider the different accounting policies that are used by each business. This can make the analysis much more difficult. For example, different methods of valuing the fixed assets could distort the Return on Capital Employed, which is an important ratio that indicates the profitability of the organisation. If the Fixed Assets have been revalued, it may appear that the return is lower than in a business that uses historic cost to value the Fixed Assets. Different rates of depreciation could also exacerbate this problem and it is therefore, necessary to compare the Accounting Policies carefully before drawing any conclusions about the relative performance or financial position of the two firms. An example will be used to illustrate the different ratios that are discussed. The Profit and Loss account and Balance Sheet of Bailie plc, a quoted company, are as follows: -
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CHAPTER 5 - THE INTERPRETATION OF FINANCIAL REPORTS
million Profit and Loss account Sales Cost of goods sold Gross profit Expenses Net profit before interest and tax Interest expense Net profit before tax Tax for the year Net profit after interest and tax Dividends for the year Profit retained 2001 150 50 100 72 28 2 26 4 22 5 17 2002 175 88 87 67 20 3 17 2 15 2 13
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Balance sheet Fixed assets (at cost less accumulated depreciation) Current assets Stock Debtors Cash 10 30 10 60 Less: Current Liabilities - Creditors Net Current assets Net Total assets Less: Long-term debt 30 30 180 110 70 Issued shares 100 million shares at 20p each Retained profit 20 50 70 Share price at the end of the financial year 300p 150
2001
2002
260
16 50 2 68 39 29 289 206 83 20 63 83 200p
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STEP 1 - An overview
Scrutinise the Profit and Loss account and Balance Sheet to get an overall view of the trends that can be seen from the financial statements. The growth in Sales and Operating Profit are two areas that should be looked at initially as these two area will probably be important in the analysis of the overall performance of the business. The sales of Bailie plc have increased by 16.7% but the Net Profit before Tax has fallen from 26 million to 17 million, which is nearly a 35% fall. This will need to be explained, as the companys stakeholders will be concerned about a decline in profitability of this magnitude.
STEP 2 - Profitability
Profitability is a good starting point as most firms are profit seeking, even if they do not achieve always achieve this objective. It is difficult to analyse a not-for-profit organisation as non-financial factors are relevant and it is often not easy to measure these objectively. For example, the effectiveness of an educational institution or a government department can be interpreted in different ways. The Gross Profit Margin shows the extent to which the Sales exceed the Cost of Sales. The ratio is calculated as: Gross Profit Margin
Gross Profit 100 Sales

In 2001, the Gross Profit margin of Bailie plc was 66.7% (100 / 150) but this falls to just below 50% (87 / 150) in 2002. Although the company has been successful at increasing Sales, it has either reduced the selling prices or failed to increase the selling prices in relation to the increase in costs that has occurred during 2002. The actions of competitors may be a factor in the explanation of this decrease in the Gross
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Profit. The strength of the competition may have meant that Bailies management could not increase the selling prices in proportion to the increases in the cost of either the manufacture or purchase price of the goods sold. Alternatively, significant losses through spoilage or theft may have occurred but another avenue that should be investigated is that the firm may have entered into contracts, which do not allow the selling price to be increased. This would result in the Gross Profit Margin decreasing if costs escalate. In a later Unit, the behaviour of costs will be discussed. However, it is important to recognise that many costs are relatively fixed. This means that the total costs will not change if the output increases or decreases. The best example of a fixed cost is Rent as the landlord cannot expect more rent to be paid if the factory increases either its output or profit. Depreciation is another cost, which is always fixed, and this can be a significant expense in the Profit and Loss Account if expensive machinery is used in the production process. The depreciation cost will be part of the Cost of Sales but it will not change if the production level changes. This means that if the Sales units increase, the fixed costs in the Cost of Sales will be unchanged and so the Gross Profit Margin would be expected to increase. This has not occurred and so the cause of the increased costs must be investigated. The causes of the change in the Gross Profit Margin will not be evident from the financial statements. This means that a special investigation will be needed to establish the cause of the problem. A bar is a particularly difficult business to control and well-organised pubs calculate the Gross Profit Margin daily. This means that if either drinks are given away to friends, staff consume excessive amounts of the stock or steal cash. In all these cases, the Gross Profit Margin would be lower than expected. Therefore, by determining the Gross Profit Margin daily, steps can be taken immediately to establish the cause of the decreased profitability. The Net Profit Margin is the next ratio that should be calculated. The ratio is: Net Profit Margin
Net Profit Before Interest And Tax 100 Sales
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From the Bailie plc financial reports, it can be determined that the Net profit Margins are 18.7% (28 / 150) in 2001 and 11.4% (20 / 175) in 2002. Although these ratios are significant, it is important to monitor the difference between the Gross Profit Margin and the Net Profit Margin as this represents the ratio of Expenses to Sales. In 2001, the Expenses are 48% (66.7 18.7) but this falls to only 38.6% in 2002. This shows that the total expenses have decreased and so the decreased Gross Profit Margin is responsible for the decreased profitability. Net profit before Interest and Tax is usually used as this eliminates the effect of the amount of Interest paid. A large increase in the amount of debt would usually increase the Interest paid and this might give the impression that the firm has become less profitable. To some extent this is true as the Net Profit has decreased but this is caused by the change in the Capital Structure of the firm. This will be considered in greater depth when the Gearing ratios are calculated. At this stage, it is important that the profitability is assessed in terms of the resources that are being used. These are, probably, the most important ratios as they measure the performance of the firm. Basically, if a better return could be obtained from another investment, then the assets should be sold and the proceeds invested in the more profitable venture. It would, however, be important to consider the risk involved in each investment. The ratio that is usually used is: Return on Capital Employed (ROCE)
Net Profit Before Interest and Taxation 100 Share Capital Reserves L / T Debt
Using the Bailie plc example, the ROCE is 15.6% and it falls to 6.9% in 2002. The figures are 28 / (2 + 68 + 110) and 20 / (2 + 81 + 206). From the previous ratios, it is known that profit had fallen. However, the ROCE has also been affected by the increase in resources that are being used in 2002. This means that ROCE of the company has decreased dramatically and this is a matter that the accountant should bring to the attention of the management. A variation on ROCE is the Return on
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Shareholders Funds. This looks at profitability from the perspective of the providers of equity after Tax to a company. This means that it is better to use the Net Profit. This is the profit that is available to the shareholders and so this should be considered in relation to the funds that they have invested in the company, as reflected in the Balance Sheet. Of course, the shareholders stake is affected by the manner in which the assets are valued as the Shareholders Funds. The assets are on the other side of the Balance Sheet from the Shareholders Funds and will be affected by the values placed on the assets. This will obviously affect the Return on Shareholders funds. The ratio that is used to determine the return to the shareholders is: Return on Shareholders Funds
Net Profit After Tax And Preference Dividends 100 Ordinary Share Capital Reserves
In the Bailie plc example, the Return on Shareholders Funds is 31.4% in 2001. This is calculated as 22 / (2 + 68). This falls to 18.1% [15 / (2 + 81)] and the explanation of this decrease in return will include many of the factors that have already been identified. In the Bailie example, the amount of debt has increased. If the resources, which were acquired with this debt, had generated more profit than the rate of interest paid for the additional funding, then this would have increased the Return on Shareholders Funds even if the ROCE had fallen. This can be illustrated by an example.
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Year 1 Fixed Assets Net Current Assets 1 000 200 1 200 Less: Long-term debt 200 1 000 Shareholders Funds 1 000
Year 2 2 000 500 2 500 1 200 1 300 1 300
Net Profit before interest and tax Net profit after tax Return on Capital on Capital Return on Shareholders Funds
480 200 40% 20%
700 390 28% 30%
After calculating these four ratios, it is possible to obtain a good idea of the factors, which have affected the profitability of the firm. These will include the selling prices, the Cost of Sales, expenses and finally, the profit in relation to the resources that are being used. Often, the exact reasons will not be evident in the financial statements but the ratios act as a warning signal and alert the management to areas that need to be investigated. In many instances, the managers will be aware of the causes of the problems already but the ratios will highlight the significance in terms of the overall performance and financial position of the firm. Managers, who are in touch will usually be aware that it has been necessary to reduce selling prices, incur additional expenses or increase the resources that are used. These should be issues that they are addressing daily and regular reports from the management accountants should provide them with details of the performance of each part of the organisation.
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STEP 3 - Liquidity
The importance of liquidity cannot be emphasised enough, as it is essential that all organisations have cash to ensure that the day-to-day operations continue. When an organisation runs out of cash, it is dead and cannot continue to function. It is possible for a business to continue operating at a loss for many years and only when the cash reserves are depleted and the lenders have refused more credit, will the business be forced to cease trading. On these grounds, the relationship between the Current Assets and Current Liabilities must be reviewed regularly. This is usually done by means of the following two ratios: Current Ratio
Current Assets Current Liabilitie s

Acid Test Ratio
Current Assets Less Stock Current Liabilitie s

The Acid Test ratio recognises that the Stock may take time to be converted into Cash and so it is excluded from the ratio. At this stage, it is important to understand that an acceptable level for either of these ratios cannot be prescribed. The nature of the industry affects both the Current ratio and the Acid Test ratio. Many firms, particularly in Retailing, operate efficiently and safely with a Current ratio of 0.6 and an Acid Test ratio of 0.45. However, this would be a major sign of weakness in industries that require large amounts of stock to be held and also offer lengthy periods of credit to their customers. Companies, such as the major supermarkets, that have a high stock turnover and operate mainly on a cash basis, will have a relatively small investment in Stock and Debtors. This means that the Current ratio may be less than 1.0 but the firm does not have any problem of liquidity. In reviewing the Liquidity position of a firm, you should look at the amount of Cash that is available. It is necessary to consider the time that Creditors are likely to allow
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and compare this with the amount of credit that the firms Debtors are taking. This information is not usually available in the financial statements but the past trends can be assessed from the Efficiency ratios that will be discussed next.
STEP 4 - Working capital

Both raw materials and finished goods stock tend to increase if this aspect of the business is not controlled constantly. In a manufacturing business, the production staff would prefer to have large quantities of every raw material available to ensure that there is never a stock-out. At the other end of the production line, the sales staff would like to have stock of every stock item so that every request from customers can be supplied immediately. Although large amounts of stock will be popular with both these departments, the cost of holding the additional stock is likely to increase the interest paid by the business as their overdraft increases to finance the additional stock. To maintain control of the working capital, ratios are calculated to monitor the trends in the stock levels, the credit allowed to debtors and the credit received from suppliers. The ratios that are usually used are: Stock Turnover Period
Stock Held 365 Cost Of Sales
Debtors Settlement Period
Trade Debtors 365 Sales

Trade Creditors Period
Trade Creditors 365 Cost Of Sales
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In the Bailie plc example, these ratios are: -
2001 Stock Turnover period 66 days Debtors Settlement period 104 days Trade Creditors period 162 days 20/50x365 146 days 30/150x365 73 days 10/50x365 73 days
2002 16/88x365
50/175x365
39/88x365
It is clear from these ratios that the company has decreased the stock levels and this will have increased the flow of funds into the company. However, the collections from customers have increased significantly and this is a matter that will need to be investigated. It could be a lack of adequate credit control but it might reflect the fact that customers are demanding additional credit. The credit received from suppliers is high and this represents a source of short-term funds to the company. It should be ascertained that suppliers are not inflating their prices to Bailie plc, as they are known to be slow payers. Another ratio that monitors the resources being used is: Sales On Capital Employed
Sales Shareholders' Funds Long Term Loans

This considers both the Fixed Assets and the Net Current Assets. The above formula focuses on the other side of the Balance Sheet but as both sides are equal, this ratio is really providing a view of the trends in the level of assets that are being used. In Bailie plc, the ratios are 2.1 for both years (150/70) and (175/83). This indicates that the total resources have not increased. Although both the Fixed Assets and
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Current Assets increased, the decrease in Debtors and increase in Creditors and Longterm Debt have affected the Sales on Capital Employed ratio. The management, however, should not be complacent, as the financial risk of the company has changed as a result of the increased Long-term Debt
STEP 5 - Capital Structure

Companies have two means of raising funds. It is possible to either issue shares or borrow, using either long-term or short-term Debt. The return to the shareholders is by means of dividends that are declared by the Directors of the company. The dividend can be increased, decreased or kept the same and this decision is entirely at the discretion of the Board of Directors. It is common to find that the dividends are increased slightly each year provided that the cash resources are adequate. On the other hand, the interest owing on the Debt must be paid even if the company has a trading loss. If the company cannot meet the liability in respect of Interest, it will be declared insolvent. This means that there is a greater level of risk in companies that are funded mainly by Debt. This makes it very important that this aspect of the firms financial position is always monitored, as it is will be watched carefully by financial analysts. Although there are many different debt ratios, the ratios that are generally used are: Gearing Ratio
Long Term Liabilitie s 100 Share Capital Reserves Long Term Loans
Interest Cover
Profit Before Interest And Tax Interest Payable

In the Bailie plc example, the long-term debt has increased from 110 million to 206 million in 2002. These funds have been used to finance the additional Fixed Assets.
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The gearing ratio has increased from 61% (110 /180 x 100) to 71% (206/289 x 100) in 2002. Although it is not possible to decide on an acceptable level of debt, it is clear that this company is highly geared. The reaction to the high level of debt will depend on the stability of the profit generated by this company in particular and the industry as a whole. The Interest Cover is 28/2 = 14 in 2001 and 20/3 = 6.67 in 2002. The increase in debt and fall in Net Profit indicates that the management should consider the effects of this increased Gearing. It would appear that the additional funds were obtained recently as the Interest only increased by 50% when the Long-term Debt nearly doubled. This could mean that the Interest Cover next year could be even lower. It is important that you recognise the fact that all these ratios have been calculated using the figures that are shown in the Balance Sheet and Profit and Loss Account. The firms accounting policies used will affect the ratios but it can be assumed that the same accounting methods will be used. This is the convention of consistency that was discussed in Unit 2. However, if two different companies are being analysed,it is necessary to start by comparing the accounting policies that are used by each business. However, firms that are quoted on a Stock Exchange can be compared by means of the following Investment ratios.
Investment Ratios
The reward to shareholders is the dividends that are declared, usually twice each year. It is, therefore, useful to consider the rate of return that is being given to these suppliers of funds. The ratios that are commonly used are: Dividends Payout Ratio
Dividends Announced For The Year Earnings For The Year Available For Dividends
This ratio will identify the amount of the Net profit that is being given to the shareholders as dividends. In the Bailie plc, the Directors have given 22.7% of the Net Profit after Interest and Tax in 2001 but this falls to only 13.3% in 2002. This
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reflects the poorer performance and weaker financial position that has been identified in the previous analysis of the companys performance and financial position. It is possible that the cash has been used to purchase the additional Fixed Assets and this may be acceptable to the shareholders if the expansion resulted in an increase in the share price. The Dividend Yield measures the return received by the shareholders and this is a ratio that is frequently quoted in the newspapers. It will change with the daily change in the share price. Dividends Yield
Dividends Per Share 100 Market Value Per Share

As dividends are part of the return to shareholders, the dividend yield will obviously be of interest to both the existing and potential investors in the company. The increase in the price of the share would be the other return that investors will receive. Using the information supplied about Bailie plc, the dividend per share was 5 pence per share in 2001 and this falls to only 2 pence per share in 2002. With a share price of 300 pence in 2001, the dividend yield is 1.67% and only 1% in 2002. Earnings Per Share (EPS)
Earnings Available To Ordinary Shareholders Numbers Of Ordinary Shares

Companies are expected to report this figure in their Annual Report. The level of profitability is measured by this figure and it is a simple measure, which can be used to compare the performance from year to year or the profitability of different companies. The importance placed on this figure is questionable as the number of issued shares is relatively meaningless. There would be no significant difference if a company were to issue either one million 1 shares or two million 50 pence shares but the EPS would be halved.
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As there are 100 million shares issued throughout the period under review, the EPS for Bailie is 22 p in 2001 and 15 p in 2002. Price/Earnings Ratio (P/E ratio)
Market Value Per Share Earnings Per Share

This is another investment ratio that is frequently quoted in the financial press. Some industries have a P/E ratio of 16 to 20 and this would indicate that investors are currently prepared to pay 16 to 20 years profit for a share in the company. The implication of a high P/E ratio is that investors have confidence in the company and expect the share price to increase over the years. The P/E ratio for Bailie plc is 13.6 (300/22) in 2001 and this remains at 13.3 (200/15) in 2002. This should be compared to other companies in the same industry to get an impression of the relative confidence that investors have in the future performance of Bailie plc. If other companies in the same sector have P/E ratios of 18 to 20, then it is clear that the investors are concerned about the future of Bailie plc.
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Applications of ratio analysis

Although ratios are usually used to analyse the performance and the financial position of firms, they are useful in a number of applications. These include: using the ratios to set targets for profitability and liquidity levels as part of the budgeting process. The final output from the budgeting process is a set of financial statements that are expected at the end of the budget period. By setting targets for some of the more important ratios, the management can obtain a picture of the likely outcome of the strategy that has been accepted as the plan for the budget period. Financial analysts may be interested in predicting corporate earnings, which may be a similar, but less detailed operation. models, using ratios have been developed to predict corporate failure. In general terms, these have not been particularly successful as the complexity of the economy is difficult to incorporate into a simple model.
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Preparing financial statements as part of the budgeting process

The Bailie example, that was used previously, will now be used to show this application of ratio analysis. The management is aiming at Sales of 200 million in 2003 and they expect to achieve the following ratios: Gross Profit Margin Net Profit before interest and tax 60% 25%
The Interest expense will be 2 million. The tax rate will be 25% of the Net Profit and the dividend policy is that 50% of the Net Profit after tax. Profit and Loss account Sales Cost of goods sold Gross profit Expenses Net profit before interest and tax Interest expense Net profit before tax Tax for the year Net profit after interest and tax Dividends declared Profit retained 2002 175 88 87 72 20 3 17 2 15 2 13 2003 200 80 120 70 50 2 48 12 36 18 18
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The Profit Retained will be the first figure to be included in the new Balance Sheet. However, it is necessary for the management to take a number of decisions before the Balance Sheet can be produced. These are: million Depreciation charge for the year Stock Turnover period Debtors days Trade Creditors days Long-term debt will be reduced by 56 Notes No shares will be issued during the year. No Fixed assets will be bought or sold. The cash balance should be used to balance the Balance Sheet. 1 60 days 73 days 150 days
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Balance sheet Fixed assets (260 1) (at cost less accumulated depreciation) Current assets Stock (60/365 x 80) Debtors (73/365 x 200) Cash Less: Creditors (150/365 x 80) Tax owing Dividends owing Net Current assets Net Total assets Less: Long-term debt (206 56) 13 40 2 33 12 18
2003 259
55
(63) ( 8) 251 150 101
Issued shares 100000000 shares at 20 pence Retained profit (61 + 18)
20 79 101
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The final cash balance could be confirmed as follows: Opening cash balance Cash from Debtors (50 + 200 40) (Opening Debtors + Sales Closing Debtors) Cash paid to Creditors (39 + 80 - 3 + 69 33) (Opening Creditors + Cost of Sales less Goods from Stock + Expenses less Closing Creditors) Interest paid Long-tern Debt repaid Closing cash balance ( 2) (152) 2 210
( 56) 2
Once the Profit and Loss Account and Balance Sheet has been prepared using these target figures, the management can decide if this is an acceptable outcome. It is possible that the Profitability and the other ratios discussed in this Unit would be calculated to assist in this decision.
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Conclusion
Although ratio analysis is used widely be financial analysts, it is not the complete answer to their problems. It focuses on the important issues of profitability, liquidity, the management of working capital and the firms capital structure and the trends in all these areas should be monitored. However, it is possible that ratio analysis might fail to emphasise the relative size of the organisation, divert attention from the financial statements or ignore the particular issues that arise in an industry. If two different firms are being compared, the accounting policies of each firm must be reviewed as these can affect the results. Similarly, creative accounting can affect the figures that are shown in the financial statements and consequently, the ratios calculated. It has been suggested that readers of financial statements should: read the accounts backwards as the Notes are an important source of information; be aware that the voluntary sections provide the management with an opportunity to select the information that will presented to the readers without any constraints; read and compare the accounting policies; screen the accounts with different filters which might be to calculate the taxable income on which the tax was based, For example, if the tax rate is 25%, then the Net Profit should be four times that tax payable for the year. Despite the limitations, ratios are a very useful to both financial analysts as a means of assessing the performance and financial position of an organisation over a period of time. Although the figures are important, they provide the basis of the fundamental task, which is to interpret the results. It is necessary to consider the possible causes and effects of the changes that have occurred. The ratios should be the means to the end and not the end itself, which is the interpretation of the financial results.
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Question 1
The following information has been obtained to prepare a report which will provide an overview of the companys performance and financial position in respect of the financial years ended 28th February 2002 and 2003. 000 Balance sheets as at 28th February FIXED ASSETS (at cost less depreciation) CURRENT ASSETS Stock Debtors Cash 250 350 100 700 Less: Creditors 120 1780 Less: Long-term loans 500 1280 Issued share capital Retained profit 1000 280 1280 580 300 490 10 800 150 2150 854 1296 1000 296 1296 650 2002 1200 2003 1500
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Profit and Loss account for the years Sales Cost of Sales Gross profit Expenses Net profit before interest and tax Interest Net profit before tax Tax Net profit after tax Dividends Retained profit 3000 1350 1650 800 850 50 800 320 480 200 280 3600 2160 1440 1000 440 80 360 144 216 200 16
Required: Calculate ratios that will enable you to comment on the companys profitability, liquidity, use of working capital and the capital structure over the two year period. Prepare a report that interprets the ratios calculated in (I) and comment on the possible causes and effects of the changes that have occurred.
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Question 2
After considerable discussion, the management of PE plc have agreed on the targets to be used in preparing the companys budget for the next financial year. Profitability Sales for the year Gross profit as a percentage of Sales Net profit before interest and tax as a percentage of Sales Funding Two million shares at 20 pence each Retained profit at the beginning of the year Long-term loan Working Capital Stock Debtors Creditors Cash 1 month (based on Cost of Sales) 2 months (based on Sales) 2 months (based on Cost of Sales) This will be the balancing item in the Balance Sheet Additional information 1. 2. The fixed assets at the end of the next financial year 1 000 000 The interest paid during the year was 40 000 400 000 700 000 500 000 1 800 000 52% 30%
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3.
Tax is payable on the profit after interest at a rate of 30% and this will be paid in the following year.
4.
A dividend of 50% of the net profit after tax will be declared and it will be paid two months after the end of the financial year.
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Question 3
You have been asked to compare the performance and financial position of three companies that operate in the food retail industry. The ratios for the last financial year were:Company Gross profit % Net profit % Return on Capital Employed (after tax) Return on Shareholders funds Stock days Debtors days Required: (a) Discuss the strategy that can be identified in terms of profit and the management of working capital from these ratios. (b) (c) Discuss the financing policy adopted by each of the companies. Discuss the implications if the investment ratios of the companies are:Company Earnings per share Price earnings ratio Dividend yield X 15p 16 7% Y 20p 12 8% Y 25p 19 4% X 15 9 15 20 18 9 Y 22 10 13 13 25 32 Z 40 12 16 12 45 65
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Section 3 - Management Accounting Chapter 6 - Cost Accounting

Financial Accounting is essentially the provision of financial information to external users. Clearly, the management will be interested in the content of the financial statements but, they will require more detailed information if they are to manage the organisation efficiently and effectively. Managers need information to enable them to: assess the performance at a divisional or departmental level; take decisions which usually have financial implications; evaluate the financial outcome of different plans especially in respect of the alternative strategies that are proposed. identify areas of the business that are out of control.
The provision of information to meet the needs of the internal users is the area of Management Accounting. It is significantly different from financial accounting as there are no external rules and regulations that must be observed. In practice, accountants can choose the most effective way of presenting the information to the management. Although historical information is very important, management accounting is likely to be more future oriented, which is in stark contrast to financial accounting. Essentially, the accountants are assisting the managers to function more effectively and, to some extent, accuracy can be sacrificed to provide the managers with relevant information quickly. In Section 3, the following issues will be covered: Determining the cost of a product or service; Making short-term decisions, such as the deletion of products, make or buy decisions in respect of components that are required and also out-sourcing.
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CHAPTER 6 - COST ACCOUNTING
Finally, in Chapter 8, the role of accountants in exercising control within an organisation will be discussed. Examples will be provided of the techniques that are often used to ensure that the performance of the business is measured in an appropriate manner. Finally, the information contained in typical reports provided by management accountants will illustrate the type of information that is provided to managers to enable them to exercise control in their department or division. Essentially, management accounting is a means to an end, while financial accounting is an end in itself. There is likely to be some overlap in the information provided by the financial and management accountants. However, the management accounting information will be produced either weekly or monthly and will be more detailed than the Financial Accounting reports The differences can be presented as follows: Financial Accounting Focus Reporting entity External users The whole organisation Management Accounting Internal users Individual departments or products Function Recording past Transactions Form Regulation Financial statements Legislation, Accounting Standards and accounting practices Time orientation Historic Historic and future Management reports Accounting practices Supporting the management
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Management accounting has been broken down into the following three main areas of activity: scorekeeping, particularly in terms of the sub-units within the firm; problem solving, especially by means of ad hoc reports that tackle specific problems; attention directing to ensure that the management are aware of the areas of the business, which are out of control and require remedial attention.
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Cost terms and definitions

In the Chapters 6 and 7, aspects of financial control and decision-making will be discussed but initially, it is necessary to deal with a number of cost concepts that are fundamental to an understanding of this area of accounting. It is often difficult to link costs to specific products and services. This means that it is often embarrassing for an accountant to be asked the actual cost of a product. The problem arises as it is difficult to establish the exact amount of some of the costs that should be apportioned to each unit of output. Taking rent as an example, it is obvious that this is an expense of the firm as a whole. The total amount used during the period will be an expense and will reduce the profit in the Profit and Loss Account. As the financial statements summarise the expenses for the whole organisation, this is the correct procedure and so there is no problem in including the Rent expense in the financial statements. However, if the profitability of one of a number of different departments is being determined or the cost of one product is being calculated, then it is necessary for a portion of the rent expense to be charged to either the department or the product. What proportion of the total rent that should be charged? Should it be based on the areas occupied by the department, the number of employees employed in the department or the level of Sales or Profit generated by the department? In different circumstances, it is possible to argue a case for each of these alternatives and this is a problem that management accountants often face. It is known as the cost allocation problem. It emerges in a number of different situations and these will be discussed in the next two chapters. Initially, it is necessary to consider the way in which costs are classified. The two main categories are: Direct or Indirect, which relates to their traceability to specific units of output, and
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Variable or Fixed, which relates to the behaviour of costs and is particularly important in the area of decision making.
Direct costs
These are costs, which can be identified with specific units of output. These would include: Direct materials - raw materials in a manufacturing organisation. Direct labour the labour involved in producing the goods or services or the time spent on a specific job by a management consultant in a consultancy firm in the non-manufacturing sector. Direct overheads expenses that can be linked to specific products or services
Determining the total direct cost may involve considerable effort but essentially, it is possible to establish the cost accurately. A bookkeeping system will usually ensure that this information is recorded precisely. There may be difficulties in obtaining the accurate measurement of some of the direct costs. For example, workers may include unofficial breaks in the time recorded against a particular job. Similarly, materials could be stolen but charged against a current job. However, once the quantity has been obtained, a price will be applied to establish the cost of this material. There is a range of alternatives prices that can be used, especially when making decisions but this will be dealt with later when dealing with decision making. Basically, direct costs do not pose a major problem to accountants, as it is possible to accurately determine both the quantity used and the cost per unit of these items.
Indirect costs
These are costs that cannot be identified with specific units of production. In a factory, these might be the costs relating to the supervisory staff or the costs of renting and heating the premises. The exact total cost of each indirect cost can be established accurately but the difficulty is to link the costs to the different products
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that are manufactured. There is clearly no problem if only one product is made but it is unusual for a business to manufacture only one product. This means that the accountant will know that the total amount of each expense that has been incurred but an arbitrary split will be needed to apportion these costs to each unit of output. This introduces a subjective element into the process of determining the cost of the product or service. Although Indirect Materials are not common, every organisation has Indirect labour costs in the form of payments to employees, such as supervisors and managers, who are involved in the manufacture of the products in an indirect manner. Total overhead costs, however, usually form the bulk of the Indirect costs in most organisations. Particularly in capital-intensive industries, depreciation costs will be high and this is often a major component of the total indirect costs. In fact, overheads are sometimes the biggest single element of cost, particularly in a service industry where the material cost may be insignificant. Traditionally, the problem of allocating the costs has been resolved by means of overhead recovery rates. At the beginning of the accounting period, usually a year, an estimate is made of both the total Indirect Costs and the expected Output. This is usually expressed in direct labour hours to cope with the variety of products that are usually made in a factory. When these two figures have been estimated, it is possible to calculate a recovery rate, which will be applied to all jobs throughout the period. This means that a portion of the total overhead cost is included in each unit of output. The major difficulty is that the estimate of both the total expenses and the output may be wrong. This would mean that the total cost of each product manufactured would be either understated or overstated throughout the year. Clearly, the accountant will monitor these two elements of the overhead recovery rate but the accurate figures will probably only be known precisely at the end of the financial period, usually a year. It is obviously unacceptable for the cost of a product to be only finalised after the end of the financial year, as this could be eleven months after the time that the product was manufactured. If the cost of the product were needed for decision-making purposes, setting selling prices or stopping the production of unprofitable products, this would be less than satisfactory.
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Example 6.1
If the total indirect costs are expected to be 300 000 and it is estimated that 60 000 direct labour hours will be worked. Then a recovery rate of 5 per direct labour hour will be used. This means that the cost of every product will be determined by calculated the total Direct Costs and adding an amount, which will be the direct labour hours multiplied by 5. If the total direct labour hours worked was only 50 000 hours as there was a fall in demand for the firms products, then a total of only 250 000 would have been included in the cost of the products manufactured. There is an under-recovery of 50 000 even if the overheads remain at the budgeted level of 300 000. If selling price and the total cost of each unit produced is monitored continuously throughout the year, it may appear that the company has been making a profit. However, when the total costs are taken into account in the financial statements, the profit will be 50 000 lower than expected from the amount generated by each product. This is clearly an unsatisfactory position and causes difficulties for accountants, who are expected to be able to determine the cost of each product manufactured. The problem is even worse in service industries as the Indirect Costs usually are the major part of the total costs incurred. There is a further problem as it is expected that a portion of the indirect costs should be included in the value of any stock that is unsold at the end of the accounting period. When the finished goods stock is valued, the actual cost of the materials, labour and an appropriate amount of the overhead costs are used. There is no recommended method of determining the manner in which overheads are apportioned to the finished goods stock and this introduces an element of discretion into the preparation of a firms financial statements. In most cases, however, the quantity of finished goods is relatively small in relation to the total sales and so the problem may not be particularly significant.
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Example 6.2
As the accountant of a company that manufactures and sells three different products, you have been asked to determine the cost of each product so that the senior management can review the product range and stop selling any products that are making a loss. The details of the costs and selling prices are as follows:-
Direct costs
Product Anstey Brighton Clairwood Materials 10 kg. @ 2 per kg. 14 kg. @ 3 per kg 12 kg @ 4 per kg. Labour 20 hours @ 7 per hour 30 hours @ 7 per hour 50 hours @ 7 per hour
Indirect costs
Next year, the Sales Director expects that 1 000 units of each product will be sold. The budgeted expenses for the year are expected to be 900 000. If the apportionment is based on direct labour hours, then the overhead recovery rate would be 9 per direct labour hour. This means that the full-cost per unit of the products will be:Materials Anstey Brighton Clairwood 20 42 48 Labour 140 210 350 Overheads 180 270 450 Total 340 522 848 Selling Price Unit Profit 500 700 900 160 178 52
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If 1000 units of each product is sold, then the profit will be (160 000 + 178 000 + 52 000) which is a total of 390 000. At this stage, we have determined the cost of each product but this information should be used with great care, especially in relation to making decisions. ( When you have completed the next section, this example will be used to show the potential dangers of using total cost rather than the contribution approach). It is not always possible to use only one overhead recovery rate for the whole factory. Different processes may incur significantly different levels of overhead cost and so it would inappropriate to assume that a factory-wide recovery rate will provide reliable costs. In many organisations, the Depreciation expense represents a high proportion of the total overhead costs. If each product uses specific machinery, it would be inappropriate to lump them together if the costs are significantly different. An example will illustrate this more specifically:-
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Example 6.3
Three products are produced in three separate departments. The overhead costs of each department have been estimated and these are as follows:Department Depreciation A B C 44 000 20 000 1 000 Rent Other TOTAL 60 000 30 000 10 000 DLH hours 2 000 3 000 20 000 Overhead rate / dlh 30 10 0.50
8 000 8 000 4 000 6 000 6 000 3 000
In this example, department C is labour intensive and so the direct labour hours are high but the depreciation expense is small. On the basis of these overhead recovery rates, the overhead cost of a product that required one hour in each department would be 40.50. If a factory-wide rate had been used, the overhead recovery rate would have been 100 000 divided by 25 000 or 4 per direct labour hour. The product that required three hours of processing would, therefore, carry 12 of overhead costs if factorywide rates were used and this is significantly different from the 40.50, which resulted from the use of departmental overhead recovery rates. Another problem that creates problems for accountants trying to determine the cost of a product or service is the basis on which costs such as Rent should be apportioned. It would be possible to use the area used by each department but this can be problematic. To deal with these problems, the use of Activity Based Costing (ABC) has been suggested. This method of dealing with the cost allocation problem takes a different approach in order to improve the basis on which costs are apportioned to products or services. It was recognised that doing things costs money and so the cost of a
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product would be the total of each of the activities that it required to be produced. At the beginning of the period, an estimate is made of the cost of each activity. In addition, the expected total usage of this activity is estimated. This is similar to the method adopted in estimating the overhead recovery rates but it is considered to be easer to deal with each activity rather than the whole organisation. Despite the considerable publicity given to ABC, studies show that it is only being used in high-tech industries and the number of organisations that have adopted it is relatively small. This is understandable as there is still a major difficulty in estimating the quantity of resources needed by each activity. In addition, the utilisation level is likely to vary significantly. However, the increased interest in outsourcing may be linked to managers establishing the cost of activities and realising that specialists may be able to supply the service more cheaply and efficiently. However, the problems of determining the cost of a product can be significant and it is essential that managers are aware of the difficulties that can be experienced if care is not exercised in dealing with the difficulties that result from the cost allocation problem.
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Exercise 6.4
The annual budget of Hulett plc was ratified by the Directors recently and it is now necessary for the overhead recovery rates to be calculated in order to determine the cost of each of the products that are produced regularly. The monthly overhead costs and their basis of allocation to the divisions are:Expense Total Rent Supervisors 72 000 96 000 Division 1 % 20 40 35 25 Division 2 % 30 25 40 40 Division 3 % 50 35 25 35
Depreciation 80 000 Other 60 000
The budget shows that labour cost in each division will be:Division 1 Division 2 Division 3 Required: (a) Calculate the overhead recovery rates to be used in determining the cost of 95 800 @ 6 per hour = 574 800 25 400 @ 7 per hour = 177 800 15 800 @ 9 per hour = 142 200
products that are processed in each division. (b) Determine the cost of the three major jobs that were completed in the first
month of the financial year, using the overhead recovery rates calculated in (a).
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(c) and (d) the
If the firm adds 50% to the total cost of all jobs, determine the total revenue costs for the month.
Finally produce a Profit and Loss account , assuming that the expenses are at level expected when the budget was produced. Job A Job B 12 000 20 000 14 000 4 000 Job C 8 000 20 000 6 000 5 000 Job D 15 000 10 000 8 000 1 000
Materials Labour hours Division 1 Labour hours Division 2 Labour hours Division 3
5 000 25 000 10 000 3 000
The behaviour of costs

In addition to the direct / indirect classification, costs are also classified on the basis of their behaviour. Although it is generally recognised that most costs do not fall totally into the categories of Fixed and Variable, it is an important concept that will affect many of the decisions that managers take in the decisions that they make regularly. The two main categories are: -
Variable costs
These are defined as costs that will increase or decrease in direct proportion to the output. This means that if production doubles, the variable costs will also double. The best example of a variable cost is the cost of the raw materials that are used in a product. In general terms, the cost per unit will remain the same and the total will be in direct proportion to the number of units produced. In actual fact, it may be possible to obtain quantity discounts if greater quantities are required or alternatively, it may be necessary to buy in more expensive markets if the cheapest supplies have been already purchased.
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Fixed costs
These are defined as costs that will remain the same in total regardless of the quantity that is produced in a given time period. The best example is rent, as the landlord would not expect to receive less rent if the production levels were lower as a result of decreased demand for the products or a major breakdown in the production process. Fixed costs remain the same in total but the unit cost changes. For example, if the Fixed costs are 12 000 per month, the cost per unit will be as follows: Output - units 100 200 300 500 1000 Total Fixed Costs 12000 12000 12000 12000 12000 Fixed Costs per unit 120 60 40 24 12
The problem that this causes is that if the variable costs are 5 per unit, the total cost of production will be anything between 125 and 17 per unit. If there is a dramatic change in the monthly output, what should the accountant quote as the cost of this product or service? This is a major difficulty, particularly in terms of decision-making. If the selling price of the product is being reviewed, one of the first questions that will be asked will be about the actual cost of making the product. An answer of between 17 and 125 would not improve the reputation of the accountant and it is unlikely to be of much assistance in making decisions. There is a real problem with this approach to the setting of selling prices, which is called full-cost pricing. In general terms, it is sensible for managers to set the selling price at a level at which the profit will be maximised, regardless of the cost. However, this strategy, based on what the market can bear, requires knowledge of the demand at different prices rather than basing the price on the cost of production. It is often
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extremely difficult to forecast what the market can bear but it is possible to base the decision on the premise that if the selling price is greater than the variable costs, then it is covering a portion of the fixed costs, which will always be the same. It is, therefore, sensible to produce and sell every product that makes a contribution towards the fixed costs of the organisation. This approach, known as marginal pricing, does not require the fixed costs to be apportioned to individual products.
Contribution
In decision-making, this is the most important concept that is used. Contribution is the difference between the Selling Price per unit and the Variable Cost per unit. If this is positive, then the Contribution that is generated by this product or services will contribute to the amount that will cover the Fixed Costs and finally, result in profit. This can be shown as: Selling Price per unit Variable Cost per unit = Contribution per unit Once the Contribution per unit has been determined, it can be applied to the number of units of each product that is sold. This will be the Total Contribution and this must cover all the Fixed Costs. If there is still a surplus, this will represent profit. It is much easier to deal with the Fixed Costs as a total rather than trying to deal with the problems of apportioning the cost to products and so Contribution is approach when making decisions. This can be stated as: Total Contribution Total Fixed Costs = Profit and, therefore, (SP VC) x Units sold = Total Contribution Total Fixed Costs = Profit This approach to decision making treats Variable and Fixed Costs according to the assumptions that are made about their behaviour. It must be recognised that these assumptions are a gross oversimplification of the real world but it enables decisions to be made quickly. It must be remembered, however, that there is much uncertainty about any sales forecast and costs. The CVP model provides a means of assessing
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CONTRIBUTION
alternative courses of action easily but it must be recognised that it only provides a relatively rough estimate of the outcome. It is extremely useful as a screening device but more careful analysis would be needed before major changes were made. Some textbooks introduce semi-fixed and semi-variable costs but this is really only an attempt to deal with a difficult problem, namely to divide costs into the two basic categories of Variable costs and Fixed costs.
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Example 6.5
Presently a product is sold for 12 per unit. The variable cost is 5 per unit and the fixed costs are 10 000 per month. If sales are 2000 units per month, then the monthly profit will be: (SP VC) x Units sold = Total Contribution Total Fixed Costs = Profit (12 5) x 2000 = 14 000 - 10 000 = 4 000
With this as a starting point, it is possible to consider the following alternatives: 1. Increase the selling price to 14 per unit but this will result in only 1600 units being sold. (SP VC) x Units sold = Total Contribution Total Fixed Costs = Profit (14 5) x 1600 = 14 400 - 10 000 = 4 400
This proposal gives a higher total contribution and profit and should, therefore, be adopted if the sales estimate is regarded as being sound. 2. Use cheaper materials, which will reduce Variable costs by 1 per unit. The lower quality product will reduce the sales to 1850 units per month. (SP VC) x Units sold = Total Contribution Total Fixed Costs = Profit (12 4) x 1850 = 14 800 - 10 000 = 4 800
As this proposal further increases the contribution and profit, consideration should be given to the use of the cheaper material. 3. Purchase a new machine, which will increase the Fixed Costs by 300 per month. This is the additional depreciation that will be charged. However, it will reduce the variable cost by 0.50 per unit.
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(SP VC) x Units sold = Total Contribution Total Fixed Costs = Profit (12 4. 50) x 2000 = 15 000 - 10 300 = 4 700
This proposal will generate a further increase in profit and so this alternative should be implemented. 4. Finally, all the above proposals could be introduced and the sales will fall to 1500 units per month. The variable costs will be reduced by 1 + 0.50, so that it will 3.50 per unit. However, the Fixed costs will increase to 10 300 per month. (SP VC) x Units sold = Total Contribution Total Fixed Costs = Profit (14 3.50) x 1500 = 15 750 - 10 300 = 5 450
As this proposal generates the greatest profit, all the changes should be made. However, it is extremely important that the reliability of the estimates of the effect of the changes should be considered carefully.
SAQ 6.1
Fairview plc has a plant that can produce 20 000 units of Product C each year. The demand for the product is steady and it is expected that 14 000 units will be sold next year. The selling price is 9 each and the variable costs are 5 per unit. The fixed costs will be 20 000 per annum. The management have allocated 15 000 to advertise the product. Required Consider each of the following proposals separately (a) What profit is budgeted for next year if 14 000 units of Product C are sold at 9 and15 000 is spent on advertising? (b) How many units must be sold at 9 per unit to increase the budgeted profit by 20% if the advertising remains at 15 000 per annum?
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(c)
What is the maximum that could be spent on advertising the product if the campaign will increase the sales to 20 000 units at a selling price of 8 per unit? The Board of Directors expects a profit of 20 000.
(d)
It has been proposed that a new product be introduced. This product will sell for 15 per unit and the variable costs are expected to be 5 per unit. The new product is expected to take 10 minutes to produce, which is double the time taken to produce C. Should this product be produced if the factory has insufficient capacity to produce the total demand for both products?
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Conclusion
Classifying costs into the categories of Variable and Fixed costs, makes it is possible to assess different scenarios easily. This is particularly useful when alternative courses of action are being considered and this type of analysis is undertaken regularly in most businesses, especially when the annual plan is being prepared and it is necessary to consider many different courses of action. The CVP model should enable the best option to be selected.
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Chapter 7 - Short-term decisions

In Chapter 6, some of the most important cost terms were defined and the concept of Contribution was introduced. This concept is frequently used in making financial decisions. Its importance is that it recognises the assumptions relating to the behaviour of costs, namely that the total variable cost will change in proportion to the number of units and the total fixed cost will not be affected by changes in the volume of output. Although it is a gross oversimplification of reality, this simple model is very useful in making decisions.
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CHAPTER 7 - SHORT-TERM DECISIONS
Break-even analysis
It is very important that managers are aware of the level of sales at which their business makes neither a profit nor a loss. This is the break-even point and at that level of activity, the total Contribution is equal to the total Fixed Costs and so the profit is zero. In a break-even chart, the Fixed Costs, Variable Costs and consequently the Total Costs are shown for different sales levels. In addition, the Sales are also placed in the chart and the Break-even point will be at the level of sales at which the Total Costs and Total Sales intersect. Although it is always possible to construct a Break-even chart, it is easier to use the following formula. Break-even point = Total Fixed Costs / Contribution per unit. If the fixed costs are high, it will mean that a large number of units will have to be produced and sold before the Break-even point is reached. High fixed costs arise as a result of heavy advertising and promotional expenditure or expensive machinery with the corresponding high depreciation to be written off. If the contribution per unit is relatively low, then very high levels of sales will be needed to reach the break-even point. Knowing the break-even point enables the management to be aware of the likely level of profitability on a daily, weekly or monthly basis. If the sales are below the breakeven point, the managers will know that losses are being incurred and consideration should be given immediately to the remedial action required. The impact on profitability of being under or over the Break-even point will give only a very rough guide to the profit that will eventually be shown in the financial statements but as an interim guide, it can be very useful. It is important that you should be aware of assumptions that are made in respect of break-even analysis. These are: -
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Linearity of the functions it is likely that quantity discounts or the effect of the learning curve will affect the Variable Cost. In addition, the Fixed Costs are likely to change at very high and low levels of sales; It is possible to split accurately the costs into the two categories of Variable and Fixed accurately; As a portion of the fixed costs is included in the value of any unsold stock, production must equal sales in each accounting period. If this were not assumed, then the Fixed Costs would change. Only one product is old or if there is more than one product, the different products must always be sold in the same ratio. All other factors, for example, efficiency remains constant.
By making these assumptions, it is possible to estimate the break-even point and incorporate this into any short-term or long-term strategy of the firm. For example, firms that have purchased an expensive automated plant will have higher Fixed Costs but lower Variable Costs than their competitors. If all producers sell the product at the same price, then the management of the automated plant can exploit competitive advantage by selling their product at the lowest price. Depending on the price sensitivity of the buyers, it is possible that this strategy will result in a favourable outcome for the producer with the automated plant. However, the high fixed costs mean the automated firm will have a higher Break-even point and so will be required many more units, at the lower selling price, before they start to make profit. This is just one of the many decisions that can be taken if the management are aware of the behaviour of costs and the Break-even point of the business.
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Example 7.1
A company makes only one product, which sells for 15 per unit. What is the breakeven point if the variable cost per unit is 9 per unit and the total fixed costs are 60 000. The contribution per unit is 6 per unit (15 - 9) and the fixed costs are 60 000, therefore, 10 000 units must be made and sold for the total contribution to be equal to the total fixed costs. It is important to recognise that if the sales increase to 10 001 units, then the profit will be 6 as all the fixed costs have been covered and so the contribution per unit will represent profit. This shows the importance of achieving at least the break-even level of sales every day. (This also explains wht sales and marketing staff are often paid well for their services).
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Example 7.2
A company makes and sells two products that are always sold in the ratio of 1 A to 2 B, what will be the break-even point of the firm, if the fixed costs are 80 000 per annum. The details of the two products are:Product A B Selling price per unit 25 35 Variable cost per unit 17 19
The contribution per unit of Product A is 8 per unit and 16 per unit in respect of Product B. This means that the contribution of 1 A and 2 B will be 8 + 32 = 40. If the total fixed costs are 80 000, then the break-even point will be when 2 000 units of Product A and 4 000 units of Product B are sold. This can be confirmed as:Contribution Product A Product B Total contribution Total fixed costs 8 x 2000 16 x 4000 = 16 000 = 64 000 80 000 80 000 Relevant costs Whenever a financial decision is made, it is essential that the relevant costs be considered. In essence, the costs and benefits must be evaluated and the decision taken should maximise the benefits. Sometimes, it is necessary to take non-financial factors into consideration but this complicates the issues as a degree of subjectivity is introduced into the decision making process. In this Unit, decisions will be based on only financial costs and benefits. 0
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The relevant costs and benefits are: Future costs and benefits decisions that have already been made should not be considered. Sometimes, this seems strange at first sight but an example will illustrate this statement. It is expected that a project will cost 10 000 to prepare the designs required for a project. After the completion of the designs, it was established that an additional 30000 will be required to complete the project. However, it is now been ascertained that the customer is only prepared to pay 36 000. It is clearly unwise to proceed with this project as the total cost of 40 000 will exceed the benefits of 36 000. If the decision to develop the new product had been taken before the cost manufacture or the selling price were known, then the design costs, which are already committed or spent, are not relevant to the decision. They are knownas sunk costs and these should never be taken into consideration when making decisions. If the design costs of 10 000 have already been spent and the project is abandoned, the loss will be 10 000. However, if the product is sold for 36 000, the loss will decrease to only 4 000 and this is clearly a better outcome. Incremental costs both variable and fixed costs may change as a result of the decision. Both these cost elements should be taken into consideration. However, costs and benefits should be ignored if they remain the same, regardless of which decision is made. Non-apportioned costs - In the previous Unit, the difficulty of determining the cost of a product or service was discussed. The most common method of dealing with this problem is to apportion the indirect costs to the different products by means of overhead recovery rates. These are usually based on the estimated indirect costs and the expected output for the year. It is not appropriate to include these apportioned costs when making decisions, as all the additional overhead costs should be charged to the product under consideration. In many instances, there may be no additional costs involved and so these apportioned costs should be excluded. Opportunity costs - This concept focuses on the cost of what is being given up if a particular course of action is taken. It is the benefit foregone by choosing one option
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instead of the next best alternative. For example, if labour is diverted from one job to another, the relevant cost is not the amount paid to the worker but the Contribution lost if the original product cannot be made. Alternatively, if a material can be sold for much more than its cost price, then the current realisable value should be included in any quotation that uses this material. The offer of free seats in a theatre that is having difficulty filling the seats is an example of an opportunity cost. The seats would have been empty and so the opportunity cost is zero. Free or low-priced tickets are often offered to groups, who would probably not have attended the performance and so the alternative would have been empty seats, generating no income. Similarly, airlines sell seats on routes, which are usually relatively empty. The concept of relevant cost is required when evaluating both short-term and longterm decisions. The long-term decisions will usually involve discounting to determine the Net Present Value of the cash flows. heavily discounted
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Example 7.3
Bob, the builder has been asked to submit a quote for an extension to an existing home. The builder is pleased to have this enquiry as a job has been cancelled recently and there is now spare capacity and some material in stock, which can be used in this enquiry. The details are as follows: Units Required in stock Material A Material B Material C Material D 20 000 10 000 5 000 2 500 Units per unit 0 16 000 4 000 2 000 Book value value / unit 0 2 3 4 Realisable cost / unit 0 1.80 1.50 5.20 1 2.10 1.70 5.50 Replacement
The job will require 3 000 hours of skilled labour and 1 000 hours of unskilled labour. Notes: 1. Material B is used regularly in most job that the builder undertakes 2. Material C was purchased specifically for the cancelled job and is not likely to be used in any job in the near future. 3. Material D was purchased for the cancelled job but could be used as a replacement material that currently costs 6 per unit. 4. The skilled labour is part of the permanent workforce and they are paid 9 per hour. The skilled workers have at least 3 000 hours of spare capacity over the next month, which is the time that it will take to build the extension.
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5. Unskilled labour can be hired daily at a rate of 5 per hour 6. Overhead costs are added to all jobs at a rate of 7 per hour worked. This includes both skilled and unskilled labour hours. 7. The plans and specifications for the cancelled job cost 3 000 and the modifications to the plans will incur a further 1 000. What is the minimum price that Bob can quote for this job without making a Solution Material A Material B Material C 20 000 units @ 1 10 000 units @ 2.10 4 000 units @ 1.50 1 000 units @ 1.70 Material D 2 000 units @ 6.00 500 units @ 5.50 Skilled labour Unskilled labour 3 000 hours @ 0 1 000 hours @ 5 20 000 21 000 (Stock to be replaced) 6 000 (Opportunity cost) 1 700 12 000 2 750 0 (Sunk cost) loss?
5 000 1 000 69 450
Modifications to plans Total cost
This would be the minimum price that the builder could charge without being worse off after completing the contract. Bob should start the negotiations at a much higher price but would know that 69 450 was the price at which it would be better to withdraw from the negotiations.
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Short-term decision
Many different decisions are made within an organisation and most have financial implications. Each decision requires the relevant costs and benefits to be considered and in many instances, the process will be simplified by the use of the contribution approach. Examples of several different decisions will be given to illustrate the approach taken by accountants.
Addition or deletion of a product

Buzz Limited makes three products and a recent report showed the following results for the last financial period. Product Sales units A 40 Sales Variable costs Fixed costs Profit / (Loss) 4 000 1 000 1 800 1 200 B 50 2 500 750 2 000 ( 250) C 60 3 600 1 200 2 000 400 10 100 2 950 5 800 1 350 TOTAL
The fixed overheads are apportioned to products on the basis of direct labour hours. On the basis of this information, should the company stop selling product B, as it is impossible to increase the selling price?
Answer
The company should continue to make Product B as it is making a positive contribution of 1 750 or 35 per unit sold. Unless an alternative product can be sold,
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they will be better off by the 1 750 as it must be assumed that the Total Fixed costs will remain at 5 800 even if Product B is deleted from the product range. Similarly, a new product should only be introduced if it generates a positive contribution. It may result in a loss after charging the apportioned companys fixed costs have been included by means of the current overhead recovery rate but that is not significant if it is generating a positive contribution. Airlines, often offer cheap seats on the basis that any contribution towards the fixed costs puts the company in a better position than if there were an empty seat on the plane. All that must be covered is the cost of the food provided, if a fixed order is not placed for each flight and possibly, the tiny increase in fuel consumption that results from having an extra passenger on board.
Make or buy a component

A company needs a component and the accounting department has estimated the cost of producing the item as follows: Materials Labour 200 hours @ 7 per hour Apportioned fixed costs 200 hours @ 12 per hour 2 400 4 800 The Purchasing department have identified a reliable outside supplier, who can supply an identical item at a delivered price of 3 000. Should the company make or buy this component? 1 000 1 400
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Answer
The company should make the product, as the apportioned fixed costs should not be taken into account. This means that the total variable costs of 2 400 must be compared with the purchase price of 3 000. The company would incur the fixed costs even if the component were purchased. This means that the apportioned fixed costs are not relevant to this decision. If additional fixed costs were to be incurred, then they should be included in the calculations. There seems to have been a much greater interest in outsourcing in recent years. Firms are focussing on their core competencies and this means that the possibilities of the Make or Buy must be explored before any change in policy is implemented. For example, many airlines now buy the food from local hotels rather than running their own catering facilities.
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Limiting factors or resources

Managers are often faced with a short-term lack of resources. This forces them to make decisions about the products or services to be produced and sold. This decision also relies on the concept of contribution but it must now be considered as the contribution generated per unit of scarce resource used. Machine or labour hours are the most common scarce resource that occurs and the following example will illustrate the way in which this decision should be tackled. A food producer manufactures only one product but it is sold in different sizes. The details are as follows: Little Selling price per unit Variable costs per unit Fixed costs per unit Profit per unit Estimated annual sales Machine time per unit Machine time required 0.65 0.30 0.13 0.22 6 000 6 minutes 600 hours Large 1.10 0.65 0.20 0.25 5 400 10 minutes 900 hours Super 1.80 1.20 0.40 0.30 3 000 15 minutes 750 hours
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The hours required to produce the expected annual sales of all three products is a total of 2 250 machine hours. However, at the present time, the capacity of the plant is limited to a maximum of 1 800 hours. Which products should be produced to maximise the companys profit? Answer The first step is to calculate the contribution per unit and then the contribution per minute. This is: Contribution / unit Contribution / minute Little Large Super 0.30 0.45 0.60 0.050 0.045 0.040 Ranking 1 2 3
The company should produce 6 000 units of Small and 5 400 units of Large as these two products produce more contribution per machine hour than Super. The production of Little and Large will use a total of 1500 hours. This means that only 300 machine hours remain to produce 1 200 units of Super. Although Super shows the greatest profit and contribution per unit, it is the contribution per limiting factor, machine hours in this example that must be used. In the longer-term, the company should consider purchasing a new machine if the present demand for the product is expected to continue.
Conclusion
Decision-making is an important past of every managers job and it is important that the whole management team are aware of the way in which the decisions should be taken. An understanding of relevant cost and contribution is essential in the areas of short-term decision-making and also in project evaluation as it is always necessary to determine the cash flows at the outset.
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Typical examination questions

Question 1
BE plc produces four products, which are sold in packs of 1 unit of A, 3 units of B, 4 units of C and 5 units of D. The details of each product are:Product Selling price per unit Material cost per unit Labour cost per unit Overhead cost per unit Total cost per unit Profit per unit Expected monthly demand A 70 10 20 30 60 10 20 B 90 6 35 25 66 24 60 C 60 10 20 20 50 10 80 D 85 15 25 15 55 30 100
The material and labour costs are considered to be a variable. The labour rate per hour in the company is 5 per hour. Required:(a) Determine the number of packs that must be sold for the whole company to break-even. (b) (c) What is the level of profit expected each month? If the number of units of each product were 80% of the expected monthly demand, what would be the profit if the selling price per unit and the costs were at the expected level.
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(d)
If only 900 hours of labour are available each month, calculate which products should be manufactured to maximise the companys profit.
(e)
What is the maximum profit that could be generated if only 900 labour hours are available?
(f)
How much per hour could the firm pay to workers who work overtime to produce the additional products.
Question 2
The senior management of TQ plc are considering replacing an existing production facility with a new production plant that will enable several new products to be produced. There will also be significant cost savings in the cost of producing some of the companys existing products. At the briefing, the following concepts are mentioned. Opportunity costs Relevant costs Sunk costs
Required:(a) Explain these three concepts, providing an example of each concept in relation to the replacement decision that is under consideration. (b) Calculate the minimum selling price that could be charged for a special order,
assuming that the firms objective is to maximise its profit, in the following situation (i) Material C was bought for 12 per kg. An excessive amount was purchased and 300 kg. that is needed for this special order is available and will not be used in the foreseeable future. The current market price is 7 per kg.
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(ii)
Material D is in short supply and 1000 kg of material D is needed for this job. However, if an order for 200 units of another product were cancelled, it would provide the 1000 kg. of the material for this order. Each unit of the cancelled order would generate a profit of 3 per unit and 4 of fixed overheads are apportioned to each unit of the cancelled job. The original material was purchased at 5 per kg.
(iii)
This special order will use 400 hours of skilled labour, who are paid 10 per hour. The skilled workers are part of the firms permanent workforce. At present, there is sufficient spare capacity to cover the labour required to complete the special order.
(iv)
The fixed overhead recovery rate of the factory is 8 per hour and it is expected that the special order will use 400 hours.
(v)
An estimated amount of 1 200 has already been spent on the preparation of the detailed plans required for the special order.
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Question 3
A company produces three products K, L and M which use the same manufacturing facilities. The details of the budget are as follows:Product Total sales units Total sales value Total variable costs Production hours per unit Required: (a) The production management have advised that only 15 000 production hours are available. Which products should be manufactured and sold to maximise the companys profit? (b) Discuss the concept of relevant costs and illustrate your answer with examples from an investigation into the financial viability of a new product i.e. a DCF calculation. K 1 000 37 500 25 000 5 L 2 000 80 000 64 000 2 M 3 000 126 000 90 000 4
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Chapter 8 - Control
Control is an area of accounting in which information is provided so that managers can identify any part of the business that is out of control. Overspending, inefficiencies and wastage must be identified and managers must take remedial action to eliminate these undesirable occurrences. By supplying reports to the management, accountants ensure that the management are aware of any changes, particularly in respect of the revenues and costs of the organisation. It has been suggested that Control involves both deciding on what is the best course of action for the organisation and ensuring that what was supposed to happen, actually happens. In essence, the starting point of any control system is to decide on what is expected to happen and this forecast is usually based on the organisations past performance. However, it is essential that changes in the environment be taken into consideration in preparing the budget. Factors, such as the entry of a major competitor into the market, will change the likely outcome significantly. The previous years figures are always shown in the published financial statements but management accountants usually relate the performance to the budget that has been prepared. It is generally recognised that there will always be differences between the budget and the actual results achieved as there will usually be many unforeseen events as a result of the dynamic environment that exists in most industries. Although it is likely that there will be differences between the budget and the actual, the whole process of preparing the budget is usually very beneficial. Managers are forced to consider the threats and opportunities that the organisation faces and relate these to the strengths and weaknesses that exist. This means that the managers are forced to reflect on issues, which can be ignored in the day-to-day fire fighting exercises, that managers face. The budget provides the basis on which the actual performance can be evaluated. By identifying the differences between the actual and budgeted results, it is possible to isolate the factors that have changed and consideration can be given to making changes that will lead to an improvement in the future performance of the organisation.
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CHAPTER 8 - CONTROL
Anthony (1965) identified three levels of control and these are: Strategic control is the process that focuses on the broad issues of setting the organisations goals and objectives, allocating resources and deciding on the policies that are to be adopted in the process of acquiring and using the resources. Management control is the process by which managers assure that the resources are used effectively and efficiently in trying to achieve the organisations objectives. Operational control is the process to assure that specific tasks are carried out effectively and efficiently. The output in relation to the inputs determines the efficiency of an organisation. On the other hand, effectiveness is the extent to which the organisation reaches its objectives. These are essentially different ways of viewing the performance of the organisation as it is possible for an organisation to be extremely efficient but if it is not effective, then its objectives will not be achieved. For example, the production management may manufacture products at a very low cost but if they are not products that sell, the overall position is not good. Accountants should provide reports to inform the management at each of these three levels. Examples of the information that could be provided are-
Strategic control
The senior management should be provided with regular reports that summarise the performance of the whole firm. Particular problems should be highlighted but not much detail will be shown in these reports. In addition, predictions of the economic trends, changes in the industry and specific details of the competitors activities would be of interest to the senior managers who operate at the strategic level.
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Management control
The recipients of this information will be concerned at ensuring that the set goals are achieved. The reports must, therefore, show any major differences in the revenues, costs and capital employed by each division.
Operational control
The reports will provide detailed information that is relatively short-term and specific to the responsibility of the recipients. Both financial and non-financial information should be provided, as the managers will be concerned with details of the wastage and inefficiencies that have occurred in the department. At this stage, it is appropriate to look at the overall process of preparing a budget. This will be followed by a discussion of the types of reports and techniques that are used to provide the managers with the information to assess the performance of departments, divisions and the whole organisation. Budgeting and the Budgeting Process The budgeting process can be summarised as follows: 1. 2. 3. 4. 5. 6. Identify the goals of the organisation Forecast the position if nothing new is introduced Generate new strategies and evaluate their impact Rank alternatives and revise the forecast prepared at 2 Produce the plan for approval Use the plan for control purposes.
This is known as the rational method and it is used widely to prepare the budgets of organisations.
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CHAPTER 8 - CONTROL
The goals of the organisation

At the start of the budgeting process, it is necessary to identify the overall objectives of the organisation. In some instances, it will be the maximisation of profit but it is more likely that organisations will have multiple objectives, including achieving the budgeted level of profitability, growth and also non-financial goals, relating to environmental issues and the employment policies. When setting the goals, assumptions have to be made about activities of competitors and the availability of resources. In particular, the access to finance and the availability of human resources are often crucial to the plans. Typical goals may be a profitability objective at a slightly higher level than last year, growth in sales at the level of inflation and an increase in market share. Within the broad perspective of the overall objectives, it is necessary for the intermediate objectives to be set. These should be specific and measurable. For example, a company may set a profitability objective of 15% on the Capital Employed with a sales growth of 4%. If these objectives are attained when the plan is finalised, it will mean that the budget is acceptable. However, if it is not possible to reach the objectives, then the whole business will need to be reviewed and the closure of the entire enterprise considered if the objectives are not likely to be reached in the foreseeable future.
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Forecast the position if nothing new is introduced

The next step is to identify the organisations limiting factor. This is any aspect of the organisation that constrains its operations. This could be the availability of skilled labour or materials that are difficult to obtain. However, in most firms, it is the level of sales that is the limiting factor. It is, therefore, important that every effort is made to predict the future sales of both existing and new products or services. The steps in the preparation of a annual plan are:1. Produce the Sales plan In most companies, this is the starting point of the budget. It could be materials, labour or machine capacity but these can usually be increased relatively easily. On the other hand, customers are often more difficult to obtain! 2. Translate this into the Production plan When the sales budget has been prepared, it is possible to estimate the production plan after adjusting for the stock levels of finished products at the beginning and end of the budget period. The production plan is then used to determine the amounts to be expended on direct materials, direct labour and production overheads 3. Prepare expense budgets for every cost centre / department Each manager must review the operations under their control and estimate the departmental costs. This is an extremely important aspect of the budgeting process as it provides each manager with an opportunity to consider the Threats and Opportunities that are faced by their part of the business. Many managers consider the whole budgeting process to be a waste of time but despite the possibility that the plan will be out-of-date within a short time of Its preparation, the opportunity to reflect on the activities is beneficial.
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4.
Produce a Profit and Loss account This financial statement brings all the revenues and costs together and will provide the initial level of profit that will be generated. It is likely that the profit will be lower than needed to achieve the objectives because managers will usually try to build in some slack in setting both the sales targets and the levels of expenses of their areas of responsibility. This means that the revenues are often understated and the expenses and costs overstated in the first attempt at producing a budget. These issues will be reviewed in the process of authorising the budget. At this stage, the possibility of making changes to existing products and introducing new activities will need to be considered. Any opportunities that are proposed will need to be evaluated to ascertain if they will make a positive contribution. If capital expenditure is needed, then a project evaluation will need to be produced to justify the expenditure.
5.
Decide on the new assets that are needed both Fixed and Current assets The sales and production plan will indicate the need for additional fixed assets and policy decisions relating to the stock levels, debtors and the amount of credit days. This information will enable the accountant to start to produce the balance sheet but one of the most important aspects of the accountants task must be tackled. This is the preparation of the cash budget and this will indicate the additional financial resources that will be required.
6.
Produce a cash budget It is usual to produce a cash budget at the end of each month. This will indicate if there will be a temporary shortfall in cash at any time throughout the year. It is essential that the accountant is confident that there will be funds available throughout the year and so a monthly cash budget will indicate if either short-term financing, additional overdraft facilities, or long-term finance is required. If, at any time, there is insufficient cash available, the expense and capital expenditure budgets can be modified.
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7.
Combine these into the Balance Sheet The preparation of a balance sheet is the final stage in the budgeting process from the perspective of the accountant. It is now possible to determine whether the firm will be able to meet its objectives if everything goes according to the plan. It is likely, however, that a final acceptable position will not be achieved at the first attempt and many different versions will be produced before the final plan is obtained. It is an iterative process and this is one of the most important aspects of budgeting as it provides an opportunity for all the managers to consider possible courses of actions. It is generally recognised that budgeting benefits the company by ensuring that there is: Communication Co-ordination Control.
The budget will be used throughout the period as the standard against which the performance of each manager will be judged. By accepting the budget, there is agreement within each department or division of their aims and objectives and so this will be th basis on which the actual performance will be judged. In published financial statements, the previous years performance is always shown as budgets and forecasts are not usually put into the public domain. This means that all differences from the budget will be highlighted in the reports that are given to the management and this should enable the managers to take remedial action, which is the ultimate aim of the budgeting process.
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Other approaches to budgeting

Although most businesses use the Rational model, some difficulties and
disadvantages of this relatively formal method have been identified. It is thought that it is too focussed on the past performance of the organisation and it has also been suggested that it acts as a deterrent to the enterprise and the introduction of radical changes to the existing strategies of the firm. To deal with these criticisms, the freewheeling opportunism approach has been suggested. The managers in an organisation that encourages freewheeling opportunism are not criticised for decisions that result in investments that do achieve the expected level. In fact, the climate should be such that no blame is placed on the managers whose projects do not reach their target. Under these circumstances, managers will be able to take risks and the projects that do succeed will lead the organisation into new and possibly, more profitable areas. At the other end of the spectrum, some organisations, especially in the public sector, adopt an approach, which is known as incrementalism. The revenues and expenses are changed by an agreed percentage on previous levels. This means that the budget is based on the previous performance and there are obvious problems with this budgeting method, especially in a dynamic environment. It is likely that a mixture of the three approaches, rational, freewheeling opportunism and incrementalism are used in the preparation of the budgets of most large companies. The whole process is usually tackled annually but it is not uncommon for Latest Estimates to be prepared to incorporate changes that have occurred since the previous plan was prepared.
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Measuring performance
The budget will be used to evaluate the current performance of either the whole organisation, the individual divisions or to some extent, the individual managers. The targets for each manager will have been established at the time that the budget was prepared and it is vital that each manager is aware of the basis on which they will be assessed. It is known that managers will often play games when the budget is being prepared in order that they have relatively targets, which should be achieved even if there are unexpected problems during the budget period. In general terms, revenue targets are understated whilst costs and expenses will tend to be overstated. This would mean that there will be some slack in the system and so this makes it more likely that managers will reach their targets. On the other hand, it is possible that managers may feel free to spend all the budgeted expenses even if the expenditure is no longer considered to be really essential. These are issues that are raised by people who prefer the freewheeling opportunism approach to budgeting. The accounting reports must reflect the responsibilities of the people who receive the reports. Both financial and non-financial measures are now used widely to assess the performance of organisations. The reports can be classified according to the extent of the responsibility that has been delegated to the managers of each unit. These are: -
Discretionary cost centres

The amount to be spent will be at the discretion of the decision makers. During the preparation of the budget , the amount available for expenses, such as advertising and research and development, will be decided. The factors that determine the amount to be spent will include the availability of funds and the overall objectives of the firm. Although there will be a minimum amount needed to keep these departments functioning, the level of expenditure can be varied from year to year and this will clearly have an impact on the activities that can be undertaken.
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Managers in this type of department should receive regular reports that compare the actual and budgeted expenditure. For example, after six months, half the annual budget should be spent and consequently, the manager will need to either increase or decrease the expenditure in the period remaining. This type of report is the probably the simplest report that accountants produce as it will usually only show the current expenditure and the cumulative expenditure compared to the budget. An extract from a typical report provided to the manager of a discretionary cost centre may be as follows:Expense ACTUAL Current Month Salaries Other costs 12 000 57 000 Year to date 65 000 234 000 BUDGET Year to date 68 000 200 000
Engineering cost centres

Like the discretionary cost centres, the engineering cost centres are also spending departments. However, in an engineering cost centre, the level of expenditure will be affected by the output. Typically, the variable costs of a production department will increase in direct proportion to the output. However, the fixed costs, by definition, will not change. This means that if the sales increase significantly in relation to the budget, then the costs in these departments will be greater than the plan. It is important that the senior management are provided with a comparison of costs, based on a budget that has been changed to reflect the change in the output. The usual accounting technique that is used in these situations is Standard Costing. Before the beginning of the year, an estimate is prepared for each product that will be manufactured during the year. It will be necessary to obtain details of the quantity and expected cost of the materials required, the amount and hourly rate of labour needed and finally, the basis on which the overhead costs will be included in the cost of each product. It is customary to use an overhead recovery rate, based on the
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direct labour hours. This was discussed in Chapter 6. At this stage, a standard for each product will be prepared. Once the actual production of each product is known, then the expected quantities and standard cost of the materials and labour can be determined. In addition, the amount of overheads recovered will be calculated. When the actual quantities of each product manufactured is known, it is possible to calculate the quantities of material and labour hours that should have be used. Using the budgeted costs, it is also possible to determine the expected total materials and labour cost in respect of the production that has occurred. Using the overhead recovery rates, it is also possible to determine the total overhead cost that has been recovered over the period. At this stage, the actual cost of each cost element will be known through the bookkeeping and accounting procedures and this makes it possible to compare the standard and actual costs for the period. Any wastage, inefficiencies and overspendings can now be calculated and the differences (variances) analysed to indicate the areas, which are different from the original budget. The managers will then be required to take remedial action and try to minimise the impact of the changes from the forecasts made when the budget was prepared.
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Example 8.1
Amble plc manufactures and sells one product and It is expected that the costs per unit will be as follows: Material A Material B Labour Fixed Overheads 3kg. @ 2 2kg @1 1 hour @7 1 hour @9 6.00 2.00 7.00 9.00 24.00
In January, it was budgeted that 900 units would be sold. However, the sales were higher than expected and 1 000 units had been produced and sold. The financial records showed the following costs. Material A Material B Labour Fixed Overheads 2 500 kg 2 200 kg 1 400 hours 6 250 2 420 11 200 12 500 32 370
You have been asked to analyse the costs to identify any inefficiencies or overspending. It is also possible that the costs could be lower than expected. In some cases, this could be a matter of concern but generally, increased costs are the main area of concern. The first step is to adjust the budget to reflect the fact that 1000 units were produced. It is essential that the cost of the additional 100 units were manufactures and sold. The budget had been based on 900 units being manufactured.
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Most textbooks provide formulae to calculate the variances but this tends to make the process too mechanistic and it is preferable to think about the nature of the change in costs. In general terms, unfavourable Material and Labour variances show the additional quantities used or higher price of the input. This means that If more material or labour is used than expected, then the additional cost of each unit used, at the standard price, is the adverse variance. On the other hand, if more is paid for each unit used, then the additional cost will be the difference in price for every unit used. The fixed overhead variances are different. It is not expected that the expenditure will be higher than the budget and so the difference between the original budget and the actual is the spending variance. This variance is not adjusted for the change in output as it is assumed that the overhead expenses are fixed. However, a change in the quantity o the output will be shown as an over- or under-recovery of the overheads or a Volume variance. Adjusting for the increased output, changes the budget in respect of Materials and Labour and the amount of Fixed Overheads recovered to the following:Budget per unit 1000 units Material A Material B Labour Overheads 3kg. @ 2 2kg @1 1 hour @7 1 hour @9 6.00 2.00 7.00 9.00 3000 kg 2000 kg 6000 2000 2500 kg 2200 kg 6250 2420 Budget 1000 units Actual
1000 hrs 7000 1000 hrs 9000
1400hrs 11200 12500
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With this information, it is possible to see that the following changes have occurred. Material A Usage variance (3000 - 2500 kg) x 2 Price variance (2 - 2.50) x 2500 kg Material B Usage variance (2000 2200 kg) x 1 Price variance (1 - 1.1) x 2200 kg Labour Efficiency variance (1000 1400 hrs) x 7 Rate variance (7 - 8) x 1400 hours Overheads Volume variance (1000 900 hrs) x 9 Spending variance (9 x 900) - 12500 +1000 -1250 - 200 - 220 -2800 -1400 + 900 -4400 -3500 -4200 -420 -250
It is clear from this analysis that although the cost of Material A has increased, there has been a saving in terms of the usage. This can happen if a higher quality material is used but overall, the costs have increased slightly. Material B, on the other hand, shows adverse variances in respect of both the usage and price. The Labour variances are both adverse and this means that despite being paid at a higher than expected rate, the efficiency has been lower than was expected when the budget was prepared. This is a matter that will need to be examined closely. It is possible that the budget was incorrect but it is essential that the cause is determined immediately. As more than the expected number of units were produced, there was an overrecovery of the Overhead expenses but this was more than off-set by a large overspending. This is a matter that should be investigated to establish the reasons for the excess expenditure. By using a system of standard costing, it is possible to identify the causes of any factors which will change in profit from the level expected when the budget was prepared. This represents an important accounting technique that enables the senior
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management to be advised of any significant difference in the profitability of cost centres.
Profit centres
If the divisional managers are responsible for both costs and revenues, then their performance can be measured by means of a Profit and Loss account, which covers the specific area of responsibility. The way in which the profit is calculated can be problematic but it is usual for the accounting policies to be made explicit to the managers at the outset. This means that all recipients of the report will know the accounting policies, relating to such issues as the inclusion of Head Office charges and the rates of depreciation to be used. Overall, this is a relatively straightforward and understandable report. However, it is also possible to adapt the Standard Costing technique to include Sales and Profit. The cost variances will be the same as example 8.1 but there will be some additional information relating to the Sales prices charged and the effect of selling more or less than the budgeted quantities.
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Example 8.2
Amble plc manufactures and sells one product, which sells for 35 per unit. It is expected that the costs per unit will be as follows: Material A Material B Labour Overheads Profit Selling price 3kg. @ 2 2kg @1 1 hour @7 1 hour @9 6.00 2.00 7.00 9.00 24.00 11.00 35.00
In January, it was budgeted that 900 units would be sold and this would generate a profit of 9 900 (900 x 11 per unit). However, the Directors were pleased to hear that 1 000 units had been produced and sold. However, their pleasure turned to disappointment as the records showed the following result for the month: Sales Material A Material B Labour Overheads Profit / (Loss) 2 500 kg 2 200 kg 1 400 hours 6 250 2 420 11 200 12 500 32 370 (370) 32 000
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This meant that there was a total difference of 10270 and you have been asked to produce a report that explains the total difference of 10 270. Budget per unit Budget 1000 units Actual 1000 units Material A Material B Labour Overheads Profit Selling price 3kg. @ 2 2kg @1 1 hr @7 1 hour @9 6.00 2.00 7.00 9.00 11.00 35.00 3000 kg 2000 kg 1000 hrs 1000 hrs 6000 2000 7000 9000 11000 35000 2500 kg 2200 kg 1400 hrs 6250 2420 11200 12500 ( 370) 32000
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With this information, it is possible to see that the following changes have occurred. Material A Usage variance (3000 - 2500 kg) x 2 Price variance (2 - 2.50) x 2500 kg Material B Usage variance (2000 2200 kg) x 1 Price variance (1 - 1.1) x 2200 kg +1000 -1250 - 200 - 220 -420 -250
Labour Efficiency variance (1000 1400 hrs) x 7 -2800 Rate variance (7 - 8) x 1400 hours Overheads Volume variance (1000 900 hrs) x 9 Spending variance (9 x 900) - 12500 Sales Price (32 000 - 35 000) Volume (+100 units x 11) -1400 + 900 -4400 -3000 +1100 -1900 -10270 The cost variances are the same as in Example 8.1 but it is clear that the increased sales were achieved by a reduction in the selling price and despite, the increased profit generated on the additional sales, the overall effect was to reduce the profit. It is useful to consider the additional information that is provided if a Standard Costing system is introduced. If a manager is presented with a normal profit and Loss account, the usefulness of the report is relatively limited. In fact, only the bottom line is probably significant . However, with a Standard Costing system, the profit is still provided but the managers are also given details of all the deviations from the budget and this should enable them to take remedial action and so achieve the objectives of the control system. -3500 -4200
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Exercise 8.1
A firm produced and sells one product and 15 000 units are expected to be sold monthly. The product will sell for 90 per unit and the standard cost of each product is: Direct materials Direct labour Fixed overheads 10 kg. 5 hours 5 hours 12 25 40 77 During the third month of the financial year, 12 000 units were produced and sold for 1 056 000. The costs during the month were: Direct materials Direct labour Fixed overheads 130 000 kg. 56 000 hours 56 000 hours 169 000 235 200 600 000 1 004 200 You are required to prepare a report that will identify the differences between the budgeted profit for the month of 195 000 and the actual profit of 51 800.
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Solution
After calculating the budget for 120 000 units of the product, the variances are: Budgeted profit Sales volume (-3000 x 13) - price (1080 000 1 056 000) Material price (0.1 x 130 000) - usage (10 000 x 1.20) Labour rate (0.8 x 56 000) efficiency (4000 x 5) Fixed overheads volume (3000 x 40) Spending (600 000 600 000) Actual profit - 39 000 - 24 000 - 13 000 - 12 000 44 800 20 000 -120 000 -80 200 51 800 - 63 000 195 000
The final level of delegation is to give the manager responsibility for the profitability of the division. This means that the manager can make decisions about costs, selling prices and the amount invested in fixed assets and working capital.
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Investment centre
In an investment centre, the manager is responsible for all decisions about costs, revenues and the amount invested in new plant, machinery or working capital. In relation to working capital, if it is usually considered beneficial to increase the stock of finished goods only if this will result in additional sales that will outweigh the additional storage and financing costs. Similarly, if a new machine will reduce the costs of the investment centre, then the manager should invest funds in this project. Managers of investment centres will be given a target Return on Capital Employed and their performance will be monitored on this basis. The basis on which both the profit and the capital employed is determined must be made clear form the outset as these can issues which can create problems internally, especially when a manager is defending a poor performance. It is generally recognised that the performance measures that are used, will affect the way in which the unit is managed. Managers will try to show the best possible result, even if this is not in the best long-term interest of the firm. For example, the costs of maintenance may be kept to a minimum n a cost centre in order to show lower costs or higher profit. This is an issue, known as short-termism, that must be recognised by the senior management in assessing the performance of the individual responsibility centres. There are also many issues in measuring performance. It is important to be sure that the most appropriate method is used to measure the firms performance. Value based measures, such as Economic Value Added (EVA), have been developed and are currently used by many companies. EVA involves the introduction of a charge being made to cover the cost of the capital. This means that the performance of either the whole or part of the company can be compared by means of a single profit figure that takes the capital employed into consideration.
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Non-financial measures
It is generally recognised that non-financial factors are important and so this type of information must be provided to the managers in addition to the usual profitability measures. Areas that are often included in reports are: Competitiveness Market share Number of new entrants to the industry Sales growth Quality Number of complaints Quantity of defective products returned Waiting time / frequency of service Innovation Number of new products or services offered
Kaplan and Norton (1996) have developed the Balanced Scorecard (BSC) that highlights both financial and non-financial control measures to provide managers with a more complete view of the units performance. It is recognised that BSC translates mission and strategy into objectives and measures into four different perspectives. These are the drivers of current and future success and are: Financial perspectives - To succeed financially, how should we appear to our shareholders Customer perspectives - To achieve our vision, how should we appear to our customers? Internal business process - To satisfy shareholders and customers, what business processes must we excel at? Learning and growth - To achieve our vision, how will we sustain our ability to change and improve?
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Although the BSC covers a range of topics, it is a framework that provides a useful means of including many relevant areas in a control report. Each organisation will need to select factors that are particularly relevant to the management and it is likely that the BSC will be used in conjunction with other control reports. The BSC can be used at both the corporate and unit level. The financial measures are often given paramount importance and the other three sections of the BSC are often included to support the financial results. However, the BSC will focus attention of all managers on the various aspects of the business. Within an investment centre, the manager will be responsible for both costs, revenue and the return on the investment. This means that the accountant must provide a number of different reports to ensure that the manger is aware of the performance of the investment centre. The manager will, therefore, receive a cost report, a profit report and finally, an indication of the Return on Capital Employed that has been achieved each month in relation to the budget. In essence, Control is about keeping the responsible managers informed of the outcomes of their decisions and it is important to ensure that this is done speedily and in a manner that is understood by all the recipients of the information. Developments, such as the Balanced Scorecard are intended to provide the managers with information that is relevant to their needs. Anthony, R.N (1965), Planning and Control systems: A Framework for Analysis, Harvard Business School Press. Kaplan, R.S and Norton P.D. (1996), The Balanced Scorecard, Harvard Business School Press.
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1. Although managers resent the time taken up in producing an annual budget, most firms prepare and annual and 5-year plan. (a) Describe the process by which an annual plan is prepared in a manufacturing organisation. (b) 2. (a) Discuss the benefits of budgeting. Describe the information that would be relevant to a manager of:(i) a cost centre (ii) a profit centre (iii) an investment centre (b) A company has introduced a system of Standard Costing. Only one
product is produced and sold and it is expected that 12 000 units will be produced and sold each month. The fixed overheads included in the standard cost were based on a budget of 132 000 for the month. In January, 10 000 units were produced and sold and the actual fixed overheads were 144 000. You are required to calculate the fixed overhead variances for the month.
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A company manufactures and sells only one product. The monthly budget of costs and revenues is as follows:BUDGET Sales 10 000 units 50 000 ACTUAL 11 000 units 52 000
Direct materials Direct labour Fixed overheads
1 200 kg 4 000 hours 4 000 hours
6 000 16 000 24 000 46 000
1 400 kg
7 350
5 000 hours 25 000 5 000 hours 29 000 61 350
Budgeted monthly profit Actual loss for the month
4 000 9 350
The management was surprised at the result and ask for a report that will identify the area which are out of control. Required:Calculate both COST and SALES variances that will explain the difference between the budgeted monthly profit of 4 000 and the actual loss of 9 350 in January to enable the managers to take remedial action.
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Appendix A
Table A-1: Present Value of $1 Due at the End of n Periods: PVIFk ,n
1
1 k n
10% .9091 .8264 .7513 .6830 .6209 .5645 .5132 .4665 .4241 .3855 .3505 .3186 .2897 .2633 .2394 .2176 .1978 .1799 .1635 .1486 .1351 .1228 .1117 .1015 .0923 .0839 .0763 .0693 .0630 .0573 .0356 .0221 .0137 .0085 .0053 12% .8929 .7972 .7118 .6355 .5674 .5066 .4523 .4039 .3606 .3220 .2875 .2567 .2292 .2046 .1827 .1631 .1456 .1300 .1161 .1037 .0926 .0826 .0738 .0659 .0588 .0525 .0469 .0419 .0374 .0334 .0189 .0107 .0061 .0035 .0020 14% .8772 .7695 .6750 .5921 .5194 .4556 .3996 .3506 .3075 .2697 .2366 .2076 .1821 .1597 .1401 .1229 .1078 .0946 .0829 .0728 .0638 .0560 .0491 .0431 .0378 .0331 .0291 .0255 .0224 .0196 .0102 .0053 .0027 .0014 .0007 15% .8696 .7561 .6575 .5718 .4972 .4323 .3759 .3269 .2843 .2472 .2149 .1869 .1625 .1413 .1229 .1069 .0929 .0808 .0703 .0611 .0531 .0462 .0402 .0349 .0304 .0264 .0230 .0200 .0174 .0151 .0075 .0037 .0019 .0009 .0005 16% .8621 .7432 .6407 .5523 .4761 .4104 .3538 .3050 .2630 .2267 .1954 .1685 .1452 .1252 .1079 .0980 .0802 .0691 .0596 .0514 .0443 .0382 .0329 .0284 .0245 .0211 .0182 .0157 .0135 .0116 .0055 .0026 .0013 .0006 .0003 18% .8475 .7182 .6086 .5158 .4371 .3704 .3139 .2660 .2255 .1911 .1619 .1372 .1163 .0985 .0835 .0708 .0600 .0508 .0431 .0365 .0309 .0262 .0222 .0188 .0160 .0135 .0115 .0097 .0082 .0070 .0030 .0013 .0006 .0003 .0001 20% .8333 .6944 .5787 .4823 .4019 .3349 .2791 .2326 .1938 .1615 .1346 .1122 .0935 .0779 .0649 .0541 .0451 .0376 .0313 .0261 .0217 .0181 .0151 .0126 .0105 .0087 .0073 .0061 .0051 .0042 .0017 .0007 .0003 .0001 * 24% .8065 .6504 .5245 .4230 .3411 .2751 .2218 .1789 .1443 .1164 .0938 .0757 .0610 .0492 .0397 .0320 .0258 .0208 .0168 .0135 .0109 .0088 .0071 .0057 .0046 .0037 .0030 .0024 .0020 .0016 .0005 .0002 .0001 * * 28% .7813 .6104 .4768 .3725 .2910 .2274 .1776 .1388 .1084 .0847 .0662 .0517 .0404 .0316 .0247 .0193 .0150 .0118 .0092 .0072 .0056 .0044 .0034 .0027 .0021 .0016 .0013 .0010 .0008 .0006 .0002 .0001 * * * 32% .7576 .5739 .4348 .3294 .2495 .1890 .1432 .1085 .0822 .0623 .0472 .0357 .0271 .0205 .0155 .0118 .0089 .0068 .0051 .0039 .0029 .0022 .0017 .0013 .0010 .0007 .0006 .0004 .0003 .0002 .0001 * * * * 36% .7353 .5407 .3975 .2923 .2149 .1580 .1162 .0854 .0628 .0462 .0340 .0250 .0184 .0135 .0099 .0073 .0054 .0039 .0029 .0021 .0016 .0012 .0008 .0006 .0005 .0003 .0002 .0002 .0001 0.001 * * * * *
Period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 35 40 45 50 55
1% .9901 .9803 .9706 .9610 .9515 .9420 .9327 .9235 .9143 .9053 .8963 .8874 .8787 .8700 .8613 .8528 .8444 .8360 .8277 .8195 .8114 .8034 .7954 .7876 .7798 .7720 .7644 .7568 .7493 .7419 .7059 .6717 .6391 .6080 .5785
2% .9804 .9612 .9423 .9238 .9057 .8880 .8706 .8535 .8368 .8203 .8043 .7885 .7730 .7579 .7430 .7284 .7142 .7002 .6864 .6730 .6598 .6468 .6342 .6217 .6095 .5976 .5859 .5744 .5631 .5521 .5000 .4529 .4102 .3715 .3365
3% .9709 .9426 .9151 .8885 .8626 .8375 .8131 .7894 .7664 .7441 .7224 .7014 .6810 .6611 .6419 .6232 .6050 .5874 .5703 .5537 .5375 .5219 .5067 .4919 .4776 .4637 .4502 .4371 .4243 .4120 .3554 .3066 .2644 .2281 .1968
4% .9615 .9246 .8890 .8548 .8219 .7903 .7599 .7307 .7026 .6756 .6496 .6246 .6006 .5775 .5553 .5339 .5134 .4936 .4746 .4564 .4388 .4220 .4057 .3901 .3751 .3604 .3468 .3335 .3207 .3083 .2534 .2083 .1712 .1407 .1157
5% .9524 .9070 .8638 .8227 .7835 .7462 .7107 .6768 .6446 .6139 .5847 .5568 .5303 .5051 .4810 .4581 .4363 .4155 .3957 .3769 .3589 .3418 .3256 .3101 .2953 .2812 .2678 .2551 .2429 .2314 .1813 .1420 .1113 .0872 .0683
6% .9434 .8900 .8396 .7921 .7473 .7050 .6651 .6274 .5919 .5584 .5268 .4970 .4688 .4423 .4173 .3936 .3714 .3503 .3305 .3118 .2942 .2775 .2618 .2470 .2330 .2198 .2074 .1956 .1846 .1741 .1301 .0972 .0727 .0543 .0406
7% .9346 .8734 .8163 .7629 .7130 .6663 .6227 .5820 .5439 .5083 .4751 .4440 .4150 .3878 .3624 .3387 .3166 .2959 .2765 .2584 .2415 .2257 .2109 .1971 .1842 .1722 .1609 .1504 .1406 .1314 .0937 .0668 .0476 .0339 .0242
8% .9259 .8573 .7938 .7350 .6806 .6302 .5835 .5403 .5002 .4632 .4289 .3971 .3677 .3405 .3152 .2919 .2703 .2502 .2317 .2145 .1987 .1839 .1703 .1577 .1460 .1352 .1252 .1159 .1073 .0994 .0676 .0460 .0313 .0213 .0145
9% .9174 .8417 .7722 .7084 .6499 .5963 .5470 .5019 .4604 .4224 .3875 .3555 .3262 .2992 .2745 .2519 .2311 .2120 .1945 .1784 .1637 .1502 .1378 .1264 .1160 .1064 .0976 .0895 .0822 .0754 .0490 .0318 .0207 .0134 .0087
Table A-2: Present Value of an Annuity of $1 per Period for n Periods:
PVIFk ,n
t 1 1 k
1 k n
k
1 k
1 k 1 k
n
24% 0.8065 1.4568 1.9813 2.4043 2.7454 3.0205 3.2423 3.4212 3.5655 3.6819 3.7757 3.8514 3.9124 3.9616 4.0013 4.0333 4.0591 4.0799 4.0967 4.1103 4.1212 4.1300 4.1371 4.1428 4.1474 4.1511 4.1542 4.1566 4.1585 4.1601 4.1644 4.1659 4.1664 4.1666 4.1666 28% 0.7813 1.3916 1.8684 2.2410 2.5320 2.7594 2.9370 3.0758 3.1842 3.2689 3.3351 3.3868 3.4272 3.4587 3.4834 3.5026 3.5177 3.5294 3.5386 3.5458 3.5514 3.5558 3.5592 3.5619 3.5640 3.5656 3.5669 3.5679 3.5687 3.5693 3.5708 3.5712 3.5714 3.5714 3.5714 32% 0.7576 1.3315 1.7663 2.0957 2.3452 2.5342 2.6775 2.7860 2.8681 2.9304 2.9776 3.0133 3.0404 3.0609 3.0764 3.0882 3.0971 3.1039 3.1090 3.1129 3.1158 3.1180 3.1197 3.1210 3.1220 3.1227 3.1233 3.1237 3.1240 3.1242 3.1248 3.1250 3.1250 3.1250 3.1250
No. of Period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 35 40 45 50 55
1% 0.9901 1.9704 2.9410 3.9020 4.8534 5.7955 6.7282 7.6517 8.5660 9.4713 10.3676 11.2551 12.1337 13.0037 13.8651 14.7179 15.5623 16.3983 17.2260 18.0456 18.8570 19.6604 20.4558 21.2434 22.0232 22.7952 23.5596 24.3164 25.0658 25.8077 29.4086 32.8347 36.0945 39.1961 42.1472
2% 0.9804 1.9416 2.8839 3.8077 4.7135 5.6014 6.4720 7.3255 8.1622 8.9826 9.7868 10.5753 11.3484 12.1062 12.8493 13.5777 14.2919 14.9920 15.6785 16.3514 17.0112 17.6580 18.2922 18.9139 19.5235 20.1210 20.7069 21.2813 21.8444 22.3965 24.9986 27.3555 29.4902 31.4236 33.1748
3% 0.9709 1.9135 2.8286 3.7171 4.5797 5.4172 6.2303 7.0197 7.7861 8.5302 9.2526 9.9540 10.6350 11.2961 11.9379 12.5611 13.1661 13.7535 14.3238 14.8775 15.4150 15.9369 16.4436 16.9355 17.4131 17.8768 18.3270 18.7641 19.1885 19.6004 21.4872 23.1148 24.5187 25.7298 26.7744
4% 0.9615 1.8861 2.7751 3.6299 4.4518 5.2421 6.0021 6.7327 7.4353 8.1109 8.7605 9.3851 9.9856 10.5631 11.1184 11.6523 12.1657 12.6593 13.1339 13.5903 14.0292 14.4511 14.8568 15.2470 15.6221 15.9828 16.3296 16.6631 16.9837 17.2920 18.6646 19.7928 20.7200 21.4822 22.1086
5% 0.9524 1.8594 2.7232 3.5460 4.3295 5.0757 5.7864 6.4632 7.1078 7.7217 8.3064 8.8633 9.3936 9.8986 10.3797 10.8378 11.2741 11.6896 12.0853 12.4622 12.8212 13.1630 13.4886 13.7986 14.0939 14.3752 14.6430 14.8981 15.1411 15.3725 16.3742 17.1591 17.7741 18.2559 18.6335
6% 0.9434 1.8334 2.6730 3.4651 4.2124 4.9173 5.5824 6.2098 6.8017 7.3601 7.8869 8.3838 8.8527 9.2950 9.7122 10.1059 10.4773 10.8276 11.1581 11.4699 11.7641 12.0416 12.3034 12.5504 12.7834 13.0032 13.2105 13.4062 13.5907 13.7648 14.4982 15.0463 15.4558 15.7619 15.9905
7% 0.9346 1.8080 2.6243 3.3872 4.1002 4.7665 5.3893 5.9713 6.5152 7.0236 7.4987 7.9427 8.3577 8.7455 9.1079 9.4466 9.7632 10.0591 10.3356 10.5940 10.8355 11.0612 11.2722 11.4693 11.6536 11.8258 11.9867 12.1371 12.2777 12.4090 12.9477 13.3317 13.6055 13.8007 13.9399
8% 0.9259 1.7833 2.5771 3.3121 3.9927 4.6229 5.2064 5.7466 6.2469 6.7101 7.1390 7.5361 7.9038 8.2442 8.5595 8.8514 9.1216 9.3719 9.6036 9.8181 10.0168 10.2007 10.3711 10.5288 10.6748 10.8100 10.9352 11.0511 11.1584 11.2578 11.6546 11.9246 12.1084 12.2335 12.3186
9% 0.9174 1.7591 2.5313 3.2397 3.8897 4.4859 5.0030 5.5348 5.9952 6.4177 6.8052 7.1607 7.4869 7.7862 8.0607 8.3126 8.5436 8.7556 8.9501 9.1285 9.2922 9.4424 9.5802 9.7066 9.8226 9.9290 10.0266 10.1161 10.1983 10.2737 10.5668 10.7574 10.8812 10.9617 11.0140
10% 0.9091 1.7355 2.4869 3.1699 3.7908 4.3553 4.8684 5.3349 5.7590 6.1446 6.4951 6.8137 7.1034 7.3667 7.6061 7.8237 8.0216 8.2014 8.3649 8.5136 8.6487 8.7715 8.8832 8.9847 9.0770 9.1609 9.2372 9.3066 9.3696 9.4269 9.6442 9.7791 9.8628 9.9148 9.9471
12% 0.8929 1.6901 2.4018 3.0373 3.6048 4.1114 4.5638 4.9676 5.3282 5.6502 5.9377 6.1944 6.4235 6.6282 6.8109 6.9740 7.1196 7.2497 7.3658 7.4694 7.5620 7.6446 7.7184 7.7843 7.8431 7.8957 7.9426 7.9844 8.0218 8.0552 8.1755 8.2438 8.2825 8.3045 8.3170
14% 0.8772 1.6467 2.3216 2.9137 3.4331 3.8887 4.2883 4.6389 4.9464 5.2161 5.4527 5.6603 5.8424 6.0021 6.1422 6.2651 6.3729 6.4674 6.5504 6.6231 6.6870 6.7429 6.7921 6.8351 6.8729 6.9061 6.9352 6.9607 6.9830 7.0027 7.0700 7.1050 7.1232 7.1327 7.1376
15% 0.8696 1.6257 2.2832 2.8550 3.3522 3.7845 4.1604 4.4873 4.7716 5.0188 5.2337 5.4206 5.5831 5.7245 5.8474 5.9542 6.0472 6.1280 6.1982 6.2593 6.3125 6.3587 6.3988 6.4338 6.4641 6.4906 6.5135 6.5335 6.5509 6.5660 6.6166 6.6418 6.6543 6.6605 6.6636
16% 0.8621 1.6052 2.2459 2.7982 3.2743 3.6847 4.0386 4.3436 4.6065 4.8332 5.0286 5.1971 5.3423 5.4675 5.5755 5.6685 5.7487 5.8178 5.8775 5.9288 5.9731 6.0113 6.0442 6.0726 6.0971 6.1182 6.1364 6.1520 6.1656 6.1772 6.2153 6.2335 6.2421 6.2463 6.2482
18% 0.8475 1.5656 2.1743 2.6901 3.1272 3.4976 3.8115 4.0776 4.3030 4.4941 4.6560 4.7932 4.9095 5.0081 5.0916 5.1624 5.2223 5.2732 5.3162 5.3527 5.3837 5.4099 5.4321 5.4509 5.4669 5.4804 5.4919 5.5016 5.5098 5.5168 5.5386 5.5482 5.5523 5.5541 5.5549
20% .08333 1.5278 2.1065 2.5887 2.9906 3.3255 3.6046 3.8372 4.0310 4.1925 4.3271 4.4392 4.5327 4.6106 4.6755 4.7296 4.7746 4.8122 4.8435 4.8696 4.8913 4.9094 4.9245 4.9371 4.9476 4.9563 4.9636 4.9697 4.9747 4.9789 4.9915 4.9966 4.9986 4.9995 4.9998
Table A-3: Future Value of $1 at the End of n Periods:

Period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 40 50 60 1% 1.0100 1.0201 1.0303 1.0406 1.0510 1.0615 1.0721 1.0829 1.0937 1.1046 1.1157 1.1268 1.1381 1.1495 1.1610 1.1726 1.1843 1.1961 1.2081 1.2202 1.2324 1.2447 1.2572 1.2697 1.2824 1.2953 1.3082 1.3213 1.3345 1.3478 1.4889 1.6446 1.8167 2% 1.0200 1.0404 1.0612 1.0824 1.1041 1.1262 1.1487 1.1717 1.1951 1.2190 1.2434 1.2682 1.2936 1.3195 1.3459 1.3728 1.4002 1.4282 1.4568 1.4859 1.5157 1.5460 1.5769 1.6084 1.6406 1.6734 1.7069 1.7410 1.7758 1.8114 2.2080 2.6916 3.2810 3% 1.0300 1.0609 1.0927 1.1255 1.1593 1.1941 1.2299 1.2668 1.3048 1.3439 1.3842 1.4258 1.4685 1.5126 1.5580 1.6047 1.6528 1.7024 1.7535 1.8061 1.8603 1.9161 1.9736 2.0328 2.0938 2.1566 2.2213 2.2879 2.3566 2.4273 3.2620 4.3839 5.8916 4% 1.0400 1.0816 1.1249 1.1699 1.2167 1.2653 1.3159 1.3686 1.4233 1.4802 1.5395 1.6010 1.6651 1.7317 1.8009 1.8730 1.9479 2.0258 2.1068 2.1911 2.2788 2.3699 2.4647 2.5633 2.6658 2.7725 2.8834 2.9987 3.1187 3.2434 4.8010 7.1067 10.520 5% 1.0500 1.1025 1.1576 1.2155 1.2763 1.3401 1.4071 1.4775 1.5513 1.6289 1.7103 1.7959 1.8856 1.9799 2.0789 2.1829 2.2920 2.4066 2.5270 2.6533 2.7860 2.9253 3.0715 3.2251 3.3864 3.5557 3.7335 3.9201 4.1161 4.3219 7.0400 11.467 18.679 6% 1.0600 1.1236 1.1910 1.2625 1.3382 1.4185 1.5036 1.5938 1.6895 1.7908 1.8983 2.0122 2.1329 2.2609 2.3966 2.5404 2.6928 2.8543 3.0256 3.2071 3.3996 3.6035 3.8197 4.0489 4.2919 4.5494 4.8223 5.1117 5.4184 5.7435 10.286 18.420 32.988 7% 1.0700 1.1449 1.2250 1.3108 1.4026 1.5007 1.6058 1.7182 1.8385 1.9672 2.1049 2.2522 2.4098 2.5785 2.7590 2.9522 3.1588 3.3799 3.6165 3.8697 4.1406 4.4304 4.7405 5.0724 5.4274 5.8074 6.2139 6.6488 7.1143 7.6123 14.974 29.457 57.946 8% 1.0800 1.1664 1.2597 1.3605 1.4693 1.5869 1.7138 1.8509 1.9990 2.1589 2.3316 2.5182 2.7196 2.9372 3.1722 3.4259 3.7000 3.9960 4.3157 4.6610 5.0338 5.4365 5.8715 6.3412 6.8485 7.3964 7.9881 8.6271 9.3173 10.063 21.725 46.902 101.26
FVIFk ,n 1 k
10% 1.1000 1.2100 1.3310 1.4641 1.6105 1.7716 1.9487 2.1436 2.3579 2.5937 2.8531 3.1384 3.4523 3.7975 4.1772 4.5950 5.0545 5.5599 6.1159 6.7275 7.4002 8.1403 8.9543 9.8497 10.835 11.918 13.110 14.421 15.863 17.449 45.259 117.39 304.48
n
14% 1.1400 1.2996 1.4815 1.6890 1.9254 2.1950 2.5023 2.8526 3.2519 3.7072 4.2262 4.8179 5.4924 6.2613 7.1379 8.1372 9.2765 10.575 12.056 13.743 15.668 17.861 20.362 23.212 26.462 30.167 34.390 39.204 44.693 50.950 188.88 700.23 2595.9 15% 1.1500 1.3225 1.5209 1.7490 2.0114 2.3131 2.6600 3.0590 3.5179 4.0456 4.6524 5.3503 6.1528 7.0757 8.1371 9.3576 10.761 12.375 14.232 16.367 18.822 21.645 24.891 28.625 32.919 37.857 43.535 50.066 57.575 66.212 267.86 1083.7 4384.0 16% 1.1600 1.3456 1.5609 1.8106 2.1003 2.4364 2.8262 3.2784 3.8030 4.4114 5.1173 5.9360 6.8858 7.9875 9.2655 10.748 12.468 14.463 16.777 19.461 22.574 26.186 30.376 35.236 40.874 47.414 55.000 63.800 74.009 85.850 378.72 1670.7 7370.2 18% 1.1800 1.3924 1.6430 1.9388 2.2878 2.6996 3.1855 3.7589 4.4355 5.2338 6.1759 7.2876 8.5994 10.147 11.974 14.129 16.672 19.673 23.214 27.393 32.324 38.142 45.008 53.109 62.669 73.949 87.260 102.97 121.50 143.37 750.38 3927.4 20555. 20% 1.2000 1.4400 1.7280 2.0736 2.4883 2.9860 3.5832 4.2998 5.1598 6.1917 7.4301 8.9161 10.699 12.839 15.407 18.488 22.186 26.623 31.948 38.338 46.005 55.206 66.247 79.497 95.396 114.48 137.37 164.84 197.81 237.38 1469.8 9100.4 56348. 24% 1.2400 1.5376 1.9066 2.3642 2.9316 3.6352 4.5077 5.5895 6.9310 8.5944 10.657 13.215 16.386 20.319 25.196 31.243 38.741 48.039 59.568 73.864 91.592 113.57 140.83 1.74.63 216.54 268.51 332.95 412.86 511.95 634.82 5455.9 46890. * 28% 1.2800 1.6384 2.0972 2.6844 3.4360 4.3980 5.6295 7.2058 9.2234 11.806 15.112 19.343 24.759 31.691 40.565 51.923 66.461 85.071 108.89 139.38 178.41 228.36 292.30 374.14 478.90 613.00 784.64 1004.3 1285.6 1645.5 19427. * * 32% 1.3200 1.7424 2.3000 3.0360 4.0075 5.2899 6.9826 9.2170 12.166 16.060 21.199 27.983 36.937 48.757 64.359 84.954 112.14 148.02 195.39 257.92 340.45 449.39 593.20 783.02 1033.6 1364.3 1800.9 2377.2 3137.9 4142.1 66521. * * 36% 1.3600 1.8496 2.5155 3.4210 4.6526 6.3275 8.6054 11.703 15.917 21.647 29.439 40.037 54.451 74.053 100.71 136.97 186.28 253.34 344.54 468.57 637.26 866.67 1178.7 1603.0 2180.1 2964.9 4032.3 5483.9 7458.1 10143. * * *
9% 1.0900 1.1881 1.2950 1.4116 1.5386 1.6771 1.8280 1.9926 2.1719 2.3674 2.5804 2.8127 3.0658 3.3417 3.6425 3.9703 4.3276 4.7171 5.1417 5.6044 6.1088 6.6586 7.2579 7.9111 8.6231 9.3992 10.245 11.167 12.172 13.268 31.409 74.358 176.03
12% 1.1200 1.2544 1.4049 1.5735 1.7623 1.9738 2.2107 2.4760 2.7731 3.1058 3.4785 3.8960 4.3635 4.8871 5.4736 6.1304 6.8660 7.6900 8.6128 9.6463 10.804 12.100 13.552 15.179 17.000 19.040 21.325 23.884 26.750 29.960 93.051 289.00 897.60
Table A-4: Sum of an Annuity of $1 per Period for n Periods:
FVIFAk ,n
t 1
1 k n t 1 kk
15% 1.0000 2.1500 3.4725 4.9934 6.7424 8.7537 11.067 13.727 16.786 20.304 24.349 29.002 34.352 40.505 47.580 55.717 65.075 75.836 88.212 102.44 118.81 137.63 159.28 184.17 212.79 245.71 283.57 327.10 377.17 434.75 1779.1 7217.7 29220. 16% 1.0000 2.1600 3.5056 5.0665 6.8771 8.9775 11.414 14.240 17.519 21.321 25.733 30.850 36.786 43.672 51.660 60.925 71.673 84.141 98.603 115.38 134.84 157.41 183.60 213.98 249.21 290.09 337.50 392.50 456.30 530.31 2360.8 10436. 46058.
Period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 40 50 60
1% 1.0000 2.0100 3.0301 4.0604 5.1010 6.1520 7.2135 8.2857 9.3685 10.462 11.567 12.683 13.809 14.947 16.097 17.258 18.430 19.615 20.811 22.019 23.239 24.472 25.716 26.973 28.243 29.526 30.821 32.129 33.450 34.785 48.886 64.463 81.670
2% 1.0000 2.0200 3.0604 4.1216 5.2040 6.3081 7.4343 8.5830 9.7546 10.950 12.169 13.412 14.680 15.974 17.293 18.639 20.012 21.412 22.841 24.297 25.783 27.299 28.845 30.422 30.030 33.671 35.344 37.051 38.792 40.568 60.402 84.579 114.05
3% 1.0000 2.0300 3.0909 4.1836 5.3091 6.4684 7.6625 8.8923 10.159 11.464 12.808 14.192 15.618 17.086 18.599 20.157 21.762 23.414 25.117 26.870 28.676 30.537 32.453 34.426 36.459 38.553 40.710 42.931 45.219 45.575 75.401 112.80 163.05
4% 1.0000 2.0400 3.1216 4.2465 5.4163 6.6330 7.8983 9.2142 10.583 12.006 13.486 15.026 16.627 18.292 20.024 21.825 23.698 25.645 27.671 29.778 31.969 34.248 36.618 39.083 41.646 44.312 47.084 49.968 52.966 56.085 95.026 152.67 237.99
5% 1.0000 2.0500 3.1525 4.3101 5.5256 6.8019 8.1420 9.5491 11.027 12.578 14.207 15.917 17.713 19.599 21.579 23.657 25.840 28.132 30.539 33.006 35.719 38.505 41.430 44.502 47.727 51.113 54.669 58.403 62.323 66.439 120.80 209.35 353.58
6% 1.0000 2.0600 3.1836 4.3746 5.6371 6.9753 8.3938 9.8975 11.491 13.181 14.972 16.870 18.882 21.015 23.276 25.673 28.213 30.906 33.760 36.786 39.993 43.392 46.996 50.816 54.865 59.156 63.706 68.528 73.640 79.058 154.76 290.34 533.13
7% 1.0000 2.0700 3.2149 4.4399 5.7507 7.1533 8.6540 10.260 11.978 13.816 15.784 17.888 20.141 22.550 25.129 27.888 30.840 33.999 37.379 40.995 44.865 49.006 53.436 58.177 63.249 68.676 74.484 80.698 87.347 94.461 199.64 406.53 813.52
8% 1.0000 2.0800 3.2464 4.5061 5.8666 7.3359 8.9228 10.637 12.488 14.487 16.645 18.977 21.495 24.215 27.152 30.324 33.750 37.450 41.446 45.762 50.423 55.457 60.893 66.765 73.106 79.954 87.351 95.339 103.97 113.28 259.06 573.77 1253.2
9% 1.0000 2.0900 3.2781 4.5731 5.9847 7.5233 9.2004 11.028 13.021 15.193 17.560 20.141 22.953 26.019 29.361 33.003 36.974 41.301 46.018 51.160 56.765 62.873 69.532 76.790 84.701 93.324 102.72 112.97 124.14 136.31 337.88 815.08 1944.8
10% 1.0000 2.1000 3.3100 4.6410 6.1051 7.7156 9.4872 11.436 13.579 15.937 18.531 21.384 24.523 27.975 31.772 35.950 40.545 45.599 51.159 57.275 64.002 71.403 79.543 88.497 98.347 109.18 121.10 134.21 148.63 164.49 442.59 1163.9 3034.8
12% 1.0000 2.1200 3.3744 4.7793 6.3528 8.1152 10.089 12.300 14.776 17.549 20.655 24.133 28.029 32.393 37.280 42.753 48.884 55.750 63.440 72.052 81.699 92.503 104.60 118.16 133.33 150.33 169.37 190.70 214.58 241.33 767.09 2400.0 7471.6
14% 1.0000 2.1400 3.4396 4.9211 6.6101 8.5355 10.730 13.233 16.085 19.337 23.045 27.271 32.089 37.581 43.842 50.980 59.118 68.394 78.969 91.025 104.77 120.44 138.30 158.66 181.87 208.33 238.50 272.89 312.09 356.79 1342.0 4994.5 18535.
18% 1.0000 2.1800 3.5724 5.2154 7.1542 9.4420 12.142 15.327 19.086 23.521 28.755 34.931 42.219 50.818 60.965 72.939 87.068 103.74 123.41 146.63 174.02 206.34 244.49 289.49 342.60 405.27 479.22 566.48 669.45 790.95 4163.2 21813. *
20% 1.0000 2.2000 3.6400 5.3680 7.4416 9.9299 12.916 16.499 20.799 25.959 32.150 39.581 48.497 59.196 72.035 87.442 105.93 128.12 154.74 186.69 225.03 271.03 326.24 392.48 471.98 567.38 681.85 819.22 984.07 1181.9 7343.9 45497 *
24% 1.0000 2.2400 3.7776 5.6842 8.0484 10.980 14.615 19.123 24.712 31.643 40.238 50.895 64.110 80.496 100.82 126.01 157.25 195.99 244.03 303.60 377.46 469.06 582.63 723.46 898.09 1114.6 1383.1 1716.1 2129.0 2640.9 22729. * *
28% 1.0000 2.2800 3.9184 6.0156 8.6999 12.136 16.534 22.163 29.369 38.593 50.398 65.510 84.853 109.61 141.30 181.87 233.79 300.25 385.32 494.21 633.59 812.00 1040.4 1332.7 1706.8 2185.7 2798.7 3583.3 4587.7 5873.2 69377. * *
32% 1.0000 2.3200 4.0624 6.3624 9.3983 13.406 18.696 25.678 34.895 47.062 63.122 84.320 112.30 149.24 198.00 262.36 347.31 459.45 607.47 802.86 1060.8 1401.2 1850.6 2443.8 3226.8 4260.4 5624.8 7425.7 9802.9 12941. * * *
36% 1.0000 2.3600 4.2096 6.7251 10.146 14.799 21.126 29.732 41.435 57.352 78.998 108.44 148.47 202.93 276.98 377.69 514.66 700.94 954.28 1298.8 1767.4 2404.7 3271.3 4450.0 6053.0 823.13 11198.0 15230.3 20714.2 28172.3 * * *
Appendix B
Consolidated Profit and loss acount 52 weeks ended 30 March 2002 52 weeks ended 31 March 2001 Continuing Discontinuing operations Operations Total As Restated As restated As restated
Turnover Operating Profit Continuing profit Before exceptional charges Exceptional operating charges Continental European Charges Less provision made last year Other discounted operations Total operating profit Profit/(loss) on sale of property and other fixed assets Provision for loss on operations to be discontinued Loss on sale/termination of operations Loss arising on sale/closure Less provision made last year Goodwill previously written off Net loss on sale/termination of operations Net interest income Profit/loss on ordinary activities before ta Taxation on ordinary activities Profit/loss on ordinary activities after tax Minority interest (all equity) Profit/loss attributable to shareholders Dividends Retained profit/loss for the period Earnings per share Diluted earnings per share Adjusted earnings per share Diluted adjusted earnings per shar Dividend per share
Continuing Discontinuing operations operations Total Notes m m m 3 7619.4 516 8135.4
m 7342.6
m 733.1
m 8075.7
629.1 5A (42.5) 14.7 14.7 14.7
629.1 (42.5) 14.7 14.7 643.8 41.2
480.9 (26.5) (34.0) 20.1 20.1 (13.9) (0.2) (224.0)
3,4 5B 5C 5D
629.1 41.2
454.4 (83.0)
480.9 (26.5) (34.0) 20.1 20.1 440.5 (83.2) (224.0) (1.7) (1.7) (1.7) 13.9 145.5 (149.5) (4.0) (1.5) (5.5) (258.3) (263.8) (0.2)p (0.2)p 11.2p 11.2p 9.0p
6 7
9 10 10 10 10 9
(610.3) 17.6 687.9 (195.1) 492.8 1.1 493.9 (238.9) 255 17.4 17.3 15.9 15.8
(102.8) (102.8) 104.3 104.3 1.5 1.5 (368.2) (368.2) (366.7) 17.6 (352.0) 335.9 12.6 (182.5) (339.4) 153.4 (1.5) (0.4) (340.9) 153 (238.9) (340.9) (85.9) 5.4p 5.4p 16.3p 16.2p 9.5p
(1.7) (1.7) (1.7) 13.9 383.6 (146.3) 237.3 0.5 237.8 (258.3) (20.5) 8.3 8.3 11.9 11.9
(238.1) (3.2) (241.3) (2.0) (243.3) (243.3)
Note of Group historical cost profits and losses 52 weeks ended 30 March 2002 m 335.9 67.2 1.6 404.7 (17.1) 52 weeks ended 31 March 2001 As restated m 145.5 (1.3) 1.9 146.1 (263.2)
Notes Profit on ordinary activities before taxation Realisation of property revaluation surplus/(deficit) Revaluation element of depreciation charge Historical cost profit on ordinary activities before taxation Historical cost retained for the period 25 25
Consolidated statement of total recognised gains and losses 52 weeks ended 30 March 2002 m 153 0.1 0.5 153.6 (79.6) 74 52 weeks ended 31 March 2001 As restated m (5.5) 13.3 (1.7) 6.1
Notes Profit/(loss) attributable to shareholders Exchange differences on foreign currency translation Unrealised surplus/(deficit) on revaluation of investment properties Total recognised gains and losses relating to the period Prior year adjustment Total recognised gains and losses since 25 25 7.25
Prior year comparatives have been restated due to the adoption of Financial Reporting Standard (FRS) 19, 'Deferred Tax'. See note 7
Balance Sheets 30 March 2002 m
Notes Fixed assets Tangible asets land and buildings Fit out, fixtures, fittings and equipment Assets in the course of construction Investments Current assets Stocks Debtors Receivable within one year Receivable after more than one year Investments Cash at bank and in hand Current Liabilities Creditors: amounts falling due within one year Net Current assets/(liabilities) Total assets less current liabilities Creditors: amounts falling due after more than one year Provisions for liabilities and charges Net assets 20 22 13 14
Group 31 March 2001 As restated m
Company 30 March 2002 m
2166.9 1187.3 27 3381.2 50.3 3431.5 325.3
2735.2 1291.9 91.8 4118.9 58.3 4177.2 472.5 917.2 1712.1 260 154.4 3516.2 (1981.6) 1543.6 5711.8 (735.1) (395.3) 4581.4
7643.2 7643.2
15A 15B 16 17
952.1 1667.2 272.7 543.4 3760.7 (1750.8) 2009.9 5441.4 (2156.3) (203.8) 3081.3
134.2
134.2 (1858.1) (1723.9) 5919.3
19
5919.3
Capital and reserves Called up share capital 24,25 852.7 716.9 share premium account 25 2.8 Capital redemption reserve 25 1717.9 revaluation reserve 25 387.3 455.6 Other reserve 25 (542.2) 378.2 Profit and loss account 25 662.4 3015.1 Shareholders' funds (including non-equity interests) 25 3080.9 4565.8 Minority interests (all equity) 0.4 15.6 Total capital employed 3081.3 4581.4 Equity shareholders' funds 2804.9 4565.8 Non-equity shareholders' funds 276 Total shareholders' funds 3080.9 4565.8 prior year comparatives have been restated due to adoption of Financial Reporting Standards (FRS) 19, 'Deferrered Tax' see note 7.
852.7 2.8 1717.9
3345.9 5919.3 5919.3 5643.3 276 5919.3
Consolidated cash flow information For the period ended 30 March 2002 Cash flow from operating activities Returns on investments and servicing of finance Interest received Interest paid Dividends paid to minorities Net cash inflow from returns on investments and servicing of finance Taxation UK corporation tax paid Overseas tax paid Cash outflow for taxation Capital expenditure and financial investment Purchase of tangible fixed assets Sale of tangible fixed assets Purchase of fixed asset investments Sale of fixed asset investments Ne Cash inflow/(outflow) for capital expenditure and financial investment Acquisitions and disposals Closure of operations Sale of subsidiaries Repayment of loan by joint venture Cash inflow from equisitions and disposals Equity dividends paid Cash inflow before management of liquid resources and financing Management of liquid resources and financing Management of liquid resources and financing Financing Increase in cash
Notes 27
52 weeks ended 30 March 2002 m 1093.7 38.8 (2.0) 36.8 (172.0) (7.4) (179.4) (285.7) 455.6 (2.9) 9 176
52 weeks ended 31 March 2001 m 676.4 13.1 (0.5) 12.6 (164.5) (0.1) (164.6) (269.8) 18.9 (18.0) 10.7 (258.2) (0.9) (0.8) 7.6 5.9 (258.6) 13.5 263.7 (265.4) (1.7) 11.8 2001 m 11.8 (263.7) 245.9 (20.4) (26.4) (1251.4) (1277.8)
29 122.2 139.4 261.6 (256.7) 1132 28B 28C (29.1) (730.2) (759.3) 372.7
Reconciliation of net cash flow to movement in net debt Increase in cash Cash outflow/(inflow) from increase/(decrease) in liquid resources Cash (inflow)/outflow from (increase)/decrease in debt financing Exchange movements Movement in net debt Opening net debt Closing net debt
30 28B 28C
2002 m 372.7 29.1 (1031.7) 0.7 (629.2) (1277.8) (1907.0)

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Module MB1 Accounting and Finance

Integrated Graduate Development Scheme

Barry Koch Department of Accounting and Finance Copyright 2003

ACCOUNTING AND FINANCE

ACCOUNTING AND FINANCE

Exercise 8.1 Past examination questions Appendix A Appendix B

191 196 198 202

ACCOUNTING AND FINANCE

ACCOUNTING AND FINANCE

ACCOUNTING AND FINANCE

ACCOUNTING AND FINANCE

Year 2001 000

Year 2002 000 100 30 70

Year 2003 000 100 35 65

Fixed assets (at cost) Less: Accumulated Depreciation

ACCOUNTING AND FINANCE

ACCOUNTING AND FINANCE

Section 1- Finance And Financial Management

SECTION 1- FINANCE AND FINANCIAL MANAGEMENT

ACCOUNTING AND FINANCE

SECTION 1- FINANCE AND FINANCIAL MANAGEMENT

ACCOUNTING AND FINANCE

SECTION 1- FINANCE AND FINANCIAL MANAGEMENT

ACCOUNTING AND FINANCE

The evaluation of projects

ACCOUNTING AND FINANCE

What discount factor should be used?

ACCOUNTING AND FINANCE

What about the tax that is paid on the profit generated?

ACCOUNTING AND FINANCE

0.909 0.826 0.751 0.683 45.45 57.82 54.07 (8.20)

ACCOUNTING AND FINANCE

What must be included in the evaluation of a project?

WHAT MUST BE INCLUDED IN THE EVALUATION OF A PROJECT?

Proceeds of sale of existing machines and their tax implications

ACCOUNTING AND FINANCE

WHAT MUST BE INCLUDED IN THE EVALUATION OF A PROJECT?

ACCOUNTING AND FINANCE

What must be excluded in the evaluation of a project?

WHAT MUST BE INCLUDED IN THE EVALUATION OF A PROJECT?

ACCOUNTING AND FINANCE

WHAT MUST BE INCLUDED IN THE EVALUATION OF A PROJECT?

ACCOUNTING AND FINANCE

WHAT MUST BE INCLUDED IN THE EVALUATION OF A PROJECT?

Step 1 - The expected profit

ACCOUNTING AND FINANCE

Step 2 -The tax payable

Step 3 - The cash flows - 000

(9.187) (10.828) (11.484) 35.813 79.172 (11.484)

WHAT MUST BE INCLUDED IN THE EVALUATION OF A PROJECT?

Step 4 - The net present value at 10%

ACCOUNTING AND FINANCE

WHAT MUST BE INCLUDED IN THE EVALUATION OF A PROJECT?

ACCOUNTING AND FINANCE

Other ways of evaluating investments

WHAT MUST BE INCLUDED IN THE EVALUATION OF A PROJECT?

The Internal Rate of Return (IRR)

ACCOUNTING AND FINANCE

Mutually exclusive projects

WHAT MUST BE INCLUDED IN THE EVALUATION OF A PROJECT?

ACCOUNTING AND FINANCE

Multiple rates of return

WHAT MUST BE INCLUDED IN THE EVALUATION OF A PROJECT?

ACCOUNTING AND FINANCE