Star Pass Pro EPK     CIMA - Performance Operations
This Module deals with tools and techniques that generate information needed to evaluate and control present and projected performance. Both budgeting and project appraisal emphasise the critical importance of optimising cash flow. The final section of the syllabus continues this theme from the perspective of managing working capital.
  • Knowledge
  • Example
  • Activity
Basic Aspects of Management Accounting


Cost Behaviour

There are many factors click here
  that would affect the behaviour of cost. It can be inflation, interest, exchange rate fluctuations. However, in management accounting we discuss about costs which will be affected by the fluctuation in the level of activity.
Level of activity can be measured in units produced, miles travelled, This link
  hours worked, percentage of capacity used and so on.

Fixed Cost
  • This is the cost that is not affected by fluctuations in the levels of turnover or output; hence it is referred to as fixed.
  • Fixed cost can also be referred to as Period Cost. Meaning, that fixed cost is for a particular time period. E.g. Rent, Rates, Insurance and Executive salaries.
Note; when the activity level increases fixed cost per unit reduces, this is because the fixed cost does not change for a particular period; hence when the number of units increase the fixed cost is spread among the units, thereby reducing fixed cost per unit.


Variable Cost
  • This is the cost, which changes as per the level of activity. When the number of units increases the cost increases.
      E.g. Direct material, Direct Labour, Variable O/H



Semi Variable cost
  • This is the cost which contains both fixed as well as variable costs. Hence this will be affected based on the change in activity level.
E.g. Electricity - there will be a certain fixed charge and thereafter when the number of units of consumption increases then the cost would change indicating the variable cost.




Analysing Semi Variable Costs
  • In the modern business environment cost would include both fixed as well as variable hence it is important to differentiate the two costs, to determine the cost incurred for a particular activity.
There are 3 methods that can be used to separate fixed as well as variable elements,
  1. The Hi Lo Method – Identify the highest and lowest activity levels from the data and identify the change in cost which has occurred between them.
  2. The Scatter graph method – The available data should be plotted on a graph, then a line of best fit is drawn and the point at which the line cuts the vertical axis( fixed cost) Variable cost is given by the gradient of the line.
  3. The least square method of regression analysis
Breakeven or cost-volume-profit analysis (BEP/CVP)

This is the level of activity at which there is no profit or loss. That is profit = 0. It’s calculated as follows,

                                           Sales               xx
                                           (-)VC              (xx)
                                           Contribution     xx       x            Total         =  Total
                                           (-)FC                x       (x)       Contribution        FC
                                           Profit/(loss)       x        0     →   At BEP

BEP units =         Fixed Cost         
                    Contribution per unit

BE Sales Value =          TFC         x  Selling Price
      Contri. Per unit

CVP – The effect on future profits due to changes in, fixed costs, variable costs, sales price, Qty and mix. CVP is referred to as breakeven analysis.

Limitations of CVP
  • Sales revenues would not be constant, but CVP assumes it would be constant.
  • There will be changes in stocks but CVP assumes that there will be no change in stock levels.
  • This considers only the activity levels (units, miles, hrs, etc) where in the long run other factors such as inflation can affect the costs.
  • There is always the possibility of a company making losses though they are above the breakeven point due to changes in cost and revenue.
  • Charts could be only used for a single product or service, where in reality there can be more than one product or service.

Margin of safety (MOS)

If the company is planning to sell a certain no. of units above its breakeven units, this can be referred to as the MOS
The difference between the expected level of sales and the breakeven point.

MOS = Projected Sales – Breakeven Point
  • This is expressed as a percentage of projected sales.
  • The Value can be calculated, MOS Units * contribution per unit

Contribution to sales (C/S) ratio
  • Contribution to sales ratio is calculated as follows,
                                        Contribution
                                             Sales
  • This is also referred to as Profit-Volume ratio (P/V) ratio.
  • This can be used to calculate BEP in sales value,
                                        Fixed Cost
                                         C/S ratio
Target Profit. (TP)
  • If a company has a target profit to be achieved, the number of units that should be sold to achieve the target profit is,
No. of Units =         Fixed Cost + Target Profit         
                    Contribution per unit


Drawing a basic breakeven chart.

Steps in drawing a breakeven chart,

Step 01–
Select appropriate scales for the axes and draw and label them. The costs & revenues will be shown on the vertical axis and the level of activity on the horizontal axis.
Step 02–
Draw the fixed cost line and label it.
Step 03 –
Draw the total cost line and label it.
Step 04 –
Draw the revenue line and label it.




The Contribution breakeven chart.
  • One issue identified in the basic or conventional breakeven chart is the inability to read the contribution directly from the chart.
  • A contribution breakeven chart shows the variable cost line instead of the fixed cost line, other than that the principles are the same.
  • The contribution is the difference between sales revenue and the variable cost line



The PV chart. (Profit Graph or CV graph)
  • This depicts a single line according to the profit or loss at each activity level. This is another type of breakeven chart, where the breakeven point would be the line that cuts the horizontal axis.
  • The vertical axis shows the profit & losses & horizontal axis shows the activity level, it is drawn at zero profit or loss.
  • At zero activity level the loss is the fixed cost. The second point would be the calculated breakeven point or it could be the profit for sales.
  • The main point about PV to be kept in mind is the fact that it depicts the relationship between profit & BEP at any given changes in the variable.



The Economist’s breakeven chart.
  • In an economist breakeven chart the total cost & revenue lines are not a straight line as in the accountant’s breakeven chart.
  • The total cost line & revenue line takes a form of a slope where the total cost line increases from left to right, this is because marginal costs are likely to increase with output & the revenue line becomes less steep indicating the fact that to sell high number units the selling price has to be reduced



Relevant Costs

This is cost applicable to specific management decisions. It looks at the future rather than the past - cash flow items
  • Variable costs are relevant, Fixed costs are not.
  • Marginal costing principles should be considered for decision making.
  • For DM purposes, relevant costs should be considered.
  1. Opportunity Costs – CIMA terminology, as the value of the benefit sacrificed when one course of action is chosen, in preference to an alternative.
    Opportunity Cost is the amount foregone as a result of selecting the best alternative as against the next best alternative.

  2. Avoidable Costs – CIMA defines it as the specific costs of an activity or sector of a business which would be avoided if that activity or sector did not exist.
    The costs that could have been avoided if a particular activity was discontinued.

  3. Differential or Incremental Costs – CIMA defines the difference in total cost between alternatives calculated to assist DM.
    The additional cost incurred as a result of selecting one alternative.
E.g. Relevant Cost of contract A is $4700 and Relevant cost of contract B is $4100, Incremental cost is $600.
Incremental costs will This link
  help a company to identify the consequence in selecting a particular option. Hence it will help the company in the decision making.


Non Relevant Costs

These are the costs that would not be affected by a decision taken. Hence it is not relevant in DM. these include the following,
  • Sunk Cost or Past Cost – This is the cost that is already incurred and cannot be recovered. It will have no change as a result of a decision.
  • Committed Costs – This is the future cash flow that would be incurred irrespective of whatever the decision is. The company is already committed to it.
  • Notional Costs.
  • Non cash flow items such as depreciation, amortization etc.
  • Common cost – These are the costs that would be incurred whether or not the decision is made to accept the project. E.g. General Fixed Cost.


Limiting Factor Decision Making
  • A limiting factor can be identified as any factor that is scarce & would limit the progress of a particular company.
  • Availability of a resource is less than the requirement of the resource.
    E.g. Sales Volume, Machine Capacity, Skilled Labour.
The decision maker should work towards maximizing the contribution generated per unit of a limiting factor. Following steps can be used,
Step 01 – Identify the limiting factor.
Step 02 – Calculate the contribution per limiting factor for all the products.
Step 03 – Rank the products according to the contribution per limiting factor.
Step 04 –Identify the optimal prod. Schedule based on the above rankings.


Product Costing,

Direct Costs – Costs that can be directly attributed to a specific unit. E.g. Labour that forms part of the Product.
Indirect Costs – This is the cost that is incurred based on Labour, Materials or Services which cannot be directly attributed to a specific saleable unit, these are normally O/Hs of a company.


Attributing O/H costs to products & Jobs.

(a)
Production O/Hs – This will be allocated based on a particular cost centre. Where it will be allocated based on machine hrs, labour hrs etc. The relevant cost will be based on the particular absorption rate.

(b) Non Production O/Hs would be allocated based on a particular percentage (%) used by the company.




Cost Behaviour
A company has recorded the following semi variable costs,

Month. Activity Level.(units) Cost Incurred.(£)
January 1,900 37,200
February 1,750 36,250
March 2,100 39,700
April 2,450 41,150

The highest level of activity is in April & the lowest level is in February.

Solution

Basic Aspects of Management Accounting

Which of the following statements about a PV chart are true?
  • The profit line passes through the origin
  • Other things being equal, the angel of the profit line becomes steeper when the selling price increases
  • Contribution cannot be read directly from the chart
  • The point where the profit line crosses the vertical axis is the breakeven point.
  • Fixed costs are shown as line parallel to the horizontal axis

Veiw Answer

  • Knowledge
  • Example
  • Activity
Cost Accounting Systems
The Difference between Marginal costing & Absorption costing
  • The difference between the two methods lies based on the difference in the treatment of fixed production O/H. Following key points should be kept in mind.
Absorption Costing. Marginal Costing.
Production & Stocks are valued at Full Production Cost. (DM+DL+ V.Prod. O/H+F. Prod O/H) Production & Stocks are valued at Variable Production Cost. (Dm+DL+V.Prod O/H)
F. Prod. O/H absorption rate is budgeted (predetermined) and any difference to actual needs to be adjusted. (under/over Absorption) Variable Non Production Cost is separately taken to calculate contribution.
Non Prod. Cost (Fixed & Variable) are taken as period cost. All fixed costs (Production & Non Production) are taken as end period cost.


Preparing profit statements using each method

Profit Statement using Absorption Costing
Sales revenue   XXX
(-) Cost of Sales    
  Opening Stock.    
  Production.   XX
  (-) Closing Stock. (XX) (XXX)
Gross Profit   XX
Adjustment*(Under) or Over absorbed   (XX)/XX
Less    
Non Production   –VC   (XX)
                         –FC   (XX)
Profit   XXX


Reconciliation of Absorption & Marginal costing profits

(1) From one method to another.

There are 2 reasons for the reconciliation; it’s normally from marginal to absorption costing,

Fixed Prod: O/H absorption rate
  • In absorption costing items are valued using full production cost.
  • In marginal costing items are valued using variable production costs.
  • This difference is a contributory reason for profit difference.

Stock Increase or Decrease (changing Stocks)
  • This could be stock increase, decrease or no change.

Profit Reconciliation Month A Month B
Marginal Costing XXX XXX
Change in stock × FOAR XX × x XX × x
Absorption Costing XXX XXX


(2)Reconciliation from one period to another

There are 2 reconciliations,

1. From one period to another absorption costing
(A) Change in Sales Volume.

When the sales amount are different, profit amounts are also different, which would impact the revenue as well as cost. Profit per unit is calculated as follows,

Profit = S.P – Full Prod. Cost – Variable Non-Prod: Cost.

Note- All per unit Fixed Non Production Cost is not taken.

(b)Under/Over absorb adjustments of the two periods.

Absorption Costing For First Period. XXX
01. Increase/ (Decrease) in sales volume.
(Sales Volume Change*Profit Per Unit) 		XX/(XX)
02. Adjustment for (under)/over absorption.
 –First Period ( Reverse Entry )
 –Second Period ( Same Application)
(XX)/XX
(XX)/XX
Absorption Costing Profit for the second period. XX


2. From one period to another marginal costing

Like absorption costing from one period to another profit amounts are different, because of changes in sales volume. But the change is valued using contribution per unit.

Contribution = S.P – Variable Prod: Cost – Var. Non- Prod: Cost.

  • The generally accepted method for management decision making purposes is Marginal Costing. This is because the concern of the management is over the controllable costs.
  • But SSAP 9 requires the use of Absorption Costing for external reporting purposes & for general accounting purposes both fixed and variable costs should be attributed. Therefore absorption costing is in wide use.

Activity Based Costing. (ABC)

Research activities show that organizations prefer absorption costing over marginal costing. But there were 2 more problems in addition to being subjective and complicated.
  • Absorption costing was developed to an environment with few O/Hs (mostly Prod. O/Hs), but in the modern environment: There were more & more O/Hs. (mostly non production) additionally absorption costing was developed for used for orgs. With one or two types of products. The modern environment Orgs. Uses multiple products.
  • Over cost high volume products & under cost low volume products. ( Valuations are incorrect in absorption costing) Because of this ABC was developed.
  • ABC relates O/Hs to the end products using 4 steps,
  1. Identify main types of O/Hs. (Main O/Hs are called activities)
  2. Once the main O/Hs are recognized the relevant cost amounts are recognized. (Cost Pool or Cost Centre)
  3. For each of the main O/Hs relevant reasons are identified (Cost Driver)additionally cost drivers are now divided by the reasons identified. (Cost Per Driver= Cost/Reasons)
  4. Cost per driver amounts are now related to the end products by identifying the driver consumption of each product.
Level 01                                                                       Level 02
Activity → Cost Pool → Cost Driver → Cost Per Driver → End Product cost


Implications of ABC
  1. If there are higher production O/Hs.
  2. O/Hs are driven not only by volume based measures but also by a number of other reasons. Requires a method that takes multiple reasons into account.
  3. Additionally if the organization is producing multiple products with different resource consumptions a method with multiple rates is required

Activity Based Management (ABM)
  • ABM is a management idea that states, that by managing the activities of the Org. the whole Org. is eventually managed.
  • The secondary idea behind that is when the activities are managed their cost amounts are also managed, eventually managing or controlling the whole organizations. Cost.



Difference between Marginal costing & Absorption costing

The following forecasted information is available for the month of January 2011 for the company that produced a single product C

Selling price per unit              $100
Unit cost $
Direct Materials 20
Direct labour 10
Variable Production Overhead 5
Variable sales overhead 4
Fixed Production overhead per month (Budgeted and Actual)           30,000
Fixed selling overheads (Budgeted and Actual) 1,000

Budgeted activity was expected to be 1000 units and production and sales for the month of Jan were 1200 & 1000 units respectively

There were no stocks at the end of December 2010.

Requirement,
Prepare absorption & marginal costing statements for the month of January

Solution

Cost Accounting Systems

Suggest ways that a supermarket can add value to their customers.

View Answer

  • Knowledge
  • Example
  • Activity
The Theory and Practice of Standard Costing
What is a Standard?
  • Predetermined.
  • Estimate.
  • For future period.
  • Per unit/ Employee.

Standard Costing
  • A control technique which compares standard costs and revenues with actual results to obtain variances which are used to stimulate improved performance.

Types of Standards
  1. Qty Standard. (Volume/Efficiency)
  2. Price Standard. (Rate/Expenditure)
  3. Total Standard.
There is also an alternative classification based on the level of difficulty of the set standards.
  • Ideal Std– Standards set expecting a perfect performance in the next period, where there are no allowances kept for normal operational problems.
  • Attainable Standards– standards set keeping allowances for normal operational problems where it is achievable but yet challenging is known as attainable standards.
  • Current Standards– standards set based on the current performance.
  • Basic Standards–Standards kept unaltered fort a very long time period.
  • The main purpose of standard costs is to provide an idea about the actual performance. Hence it is important that it is updated on a frequent basis, In order to gather a better idea.


Setting Standards Costs - Sources of information

Standard Material Price. Standard Material Usage. Standard Labour Rate. Standard Labour Times.
Quotations & estimates of suppliers Losses and Wastage Trade Union action outcomes Technical Specifications of the tasks
Details of bulk discounts Quality of the Material Bonus schemes The Basis to be used


Variance analysis
  • Variance is the difference between std (planned or Budgeted) amounts (cost or revenue) and the actual amounts.

Variable Production Cost Variance

Material cost variance

1. Total Direct Material Cost.

(Std Material Cost Per Unit * Act. No. of units produced) – Act. Material Cost Incurred

2. Material Price Variance.

(Std Material Cost Per Kg – Act. Units Produced) * Act. Material Purchased or Used
  • Purchased – Stocks are valued based on stds.
  • Used – Stocks are valued based on actual

3. Material Usage Variance.

[(Std Material usage per Unit*Act. Units Produced) – Act. Raw Material Used] * Std Raw Material Price Per Kg.


Labour cost variance

4. Total Direct Labour Cost Variance.

(Std Labour Hrs Per Unit * Act. No. Units Produced) – Act. Labour Cost Incurred.

5. Labour Rate Variance.

(Std Labour Rate Per Hr – Act. Labour Rate Per Hr) * Actual Hrs Worked.

Act Hrs = Active Hrs + Idle Hrs.

6. Labour Efficiency Variacne.

[(Std Labour Hrs Per Unit * Act. No. Units Produced) – Act. Hrs Actively Worked] * Std Lab. Rate Per Hr

7.Idle Time Variance.

Idle Hrs * Std Lab Rate Per Hr


Variable O/H cost variance

8. Variable O/H Expenditure Variance.

(Std. Variable O/H expenditure Per Hr – Act. Variable O/H expenditure Per Active Hr) * Act. Active Hrs Worked.

9. Variable O/H Efficiency Variance.

[(Std. Hrs Per Unit *No. Of Units Produced.) – Actual Active Hrs ] * Std V. O/H Per Hr.

10. Total Variable O/H Cost Variance.

(Std. Variable O/H Cost Per Unit * Act. No. Units Produced) – Act. V. O/H Cost Incurred.



Fixed Production Cost Variance.

1. Total Fixed O/H Cost Variance.

(F.O.A.R. * Actual Activity Level) – Act. Fixed O/H Cost Incurred.


2. Fixed O/H Expenditure Variance.

Bud. Fixed O/H Cost – Act. Fixed O/H Cost


3. Fixed O/H Volume Variance.

(Bud. Units – Act. Units) * F.O.A.R


F.O.A.R = Fixed Production O/H Absorption Rate Per Unit


Sales Price Variance.

1. Sales Price Variance.

( Std. Selling Price Per Unit – Act. Selling Price Per Unit) * Act. No. of Units Sold.

2. Sales Volume Profit Variance.

( Bud. Sales Units – Act. Sales Units) * Std. Profit Per Unit.

3. Sales Volume Contribution Variance

( Bud. Sales Units – Act. Sales Units) * Std. Contribution Per Unit.

  • If the company is using marginal costing.

General Formulas

1.Total Variances,

(Std Cost Per Unit * Act. Activity Level) – Act. Cost Incurred.

2.Price Variances ( Except Fixed O/H Expenditure)

(Std Price – Act. Price) * Act Qty.

3. Qty Variances (Except For F. O/H & Sales Variances.)

[(Std. Usage Per Unit * Act. No. Of Units) – Act. Usage] * Std


Variance reconciliation
  • Any document showing the budgeted profit, the actual profit and the relevant variances is known as one of three names; an operating statement, statement of variances or statement of reconciliation.
  • The Budgeted Profit is reconciled with the Actual Profit.
  • But with all the Variances calculated based on Actual Qty any difference between Budgeted Qty and Actual Qty is accounted through the Sales Volume Variance
  • When the Sales Volume Variance is added to the Budgeted Profit the net answer created is called standard Profit.
Bud. Profit = Bud. Rate * Bud. Qty.

Act. Profit = Act. Rate * Act. Qty.

Std. Profit = Bud/Std Rate * Act. Qty.


Format Operating Statement

Budgeted Profit.     XXXX
Sales Volume Variance.     XXX/(XXX)
Standard Profit.     XXXX
Sales Price Variance.     XXX/(XXX)
Cost Variance. Adverse Favourable  
Material – Price.
            –Usage. 		     
     
Labour – Rate.
            –Efficiency.
            –Idle. 		     
     
     
Variable O/H – Expenditure.
            –Efficiency. 		     
     
Fixed O/H – Expenditure.
            –Volume. 		     
     
      XXX/(XXX)
The Theory and Practice of Standard Costing
QBD plc produces souvenirs for international airline operators. The company uses a standard absorption costing systems. The standard cost card for one of QBD plc's souvenirs is as follows;

£      
Materials    1.5kg    6.00   
Labour 1.6hrs 8.00
O/Hs
Variable 1.6hrs 4.00
Fixed 1.6hrs 12.00
Total cost 30.00
Selling price 40.00

Production & sales information for April

Budget Actual
Production 5000 units 6000 units
Sales 1.6hrs 8
Sales revenue £200,000 £164,800

The resources used & actual costs for April were as follows,

£
Materials 10,300kgs 38,720
Sales 11,420hours 71,200
O/Hs
Variable 29,650
Fixed 83,800

The 11,420 labour hours include 2,270 hours of idle time. This was caused by an unexpected machine breakdown. All of the materials purchased were used during the month.

Prepare a statement that reconciles the budgeted & actual profits/losses for April 2004 in as much detail as is possible.

Solution

The Theory and Practice of Standard Costing

"The marketing department acts as a catalyst for change". Find suitable examples from the real world to illustrate this point.

Solution

  • Knowledge
  • Example
  • Activity
Standard Costing & Performance Evaluation
Mix & Yield Variances

If there is more than 1 type of material or labour, in addition to their individual standards the individuals together also gives a new standard.
  • Mix variance
    Compares the std mix with the actual mix in order to identify whether the change is more expensive.

  • Yield Variance
    The actual mix is different to that of std mix, it might impact on the output produced.

Mix Variance Calculation

(Std Mix for Actual Total Impact – Actual Input) x Std. Price


Alternative,

Weighted Average Price = Total Weighted Std Cost
                                          Total Weight
(Std Mix For Actual Total Input – Actual Input) x Difference between the std price weighted average price


Yield Variance Calculation

(Std Yield From Actual Total Output – Actual Yield) x Std Cost Per Unit Of Output.

NOTE – The Alternative can be used too.
  • Material or Labour mix & yield variances both look into quantities and are considered as sub variances of the quantity variance.
E.g. 1. Material Mix + Material Yield = Material Usage Variance.
       2. Labour Mix + Labour Yield = Labour Efficiency Variance.

Sales Volume Variance.

1. When the normal mix variance is customized based on sales.

       (Std Mix For The Total Actual Sales – Act. Output) x Std Profit.

2. When the normal yield variance is customized based on sales.

       (Bud. Sales – Act. Sales) x Std Weighted Avg. Profit
  • If the Materials input are fundamentally different to each other (one is KGs, The other one is in LTRs & in METERs) under such conditions mix as well as yield variances are traditionally not calculated.

Planning & operational variances
  • Operational Variance – Variances which arises through factors within the control of the management.
  • Planning Variance – Variances which arises through external factors.
Planning Variance compares the Original Std & Revised Std. Operational Variance comparesthe Revised Std with the Actual.


Interpretation & Investigation of Variances

Reasons for variances

(1) Specific Reason for the orgs.

(2) General Reasons;
  • Problems with Standards Set.
  • Efficient / Inefficient Operations.
  • Efficient / Inefficient Controls or Management.
  • Errors in Recording Actual Results.
  • Macro & Micro Factors.
  • Interrelationship of Variances.

Percentage Variance charts

Variances are normally calculated in absolute terms but if it is calculated in relative or % terms then the following are the advantages.
              - Better understanding.
              - Cannot be easily manipulated.
              - Identify the trends in variances.


Investigations of Variances

It's important to identify the exact reasons as to why there is an adverse or favourable situation. For which an Org: needs to carry out an investigation. There would be a number of sales, materials, labour and O/Hs. It would not be possible to investigate everything hence the important variances should be identified. The following 3 criteria can be used;

(1) Size of the Variance

       Large scale variances are normally seen as important.

(2) Controllability

       Factors which cannot be controlled such as petrol prices would not be investigated.

(3) Cost Benefit Analysis

       If the cost of investigating is more than the variance been looked at, then it does not make business sense.


The investigation models

1.Rules of Thumb,
Involves setting limits to identify whether to investigate or not, depends on the decision makers experience and the organization's situation.

2.Statistical Significance Model
A formalized method, where standards are identified as expected avg. (mean) & variances are identified as SD. Making it possible to visualize the relationship of standards & variances as a normal distribution

3.Statistical Control Charts
Statistical model info. Is shown in a chart to make it user friendly.


Interrelationship of Variances

In certain cases adverse or favourable of a particular variance might be because of adverse or favourableness of another variance


Standard Costing in the Modern Business Environment

Criticisms & Solutions

(1) Stable Vs Dynamic Environment.
  • Standard Costing was developed in a stable business environment. So it was easy to develop Standards. But today the environment is ever changing, thus developing stds as well as achieving stds would be difficult.
  • Solution – Develop stds for shorter time period.

(2) Cost Control or Cost Management.
  • Traditionally it was about setting stds and achieving it. The modern idea is continuous improvement.
  • Solution – Set difficult stds.

(3) Labour centric or Machine Centric.
  • Traditionally most stds were developed based on labour hrs, but the modern environment uses more machines.
  • Solution – Develop stds based on machine hrs.

(4) Standards & Behavioural Implications.
  • Stds were implemented and when employees were considered as workers. Modern Environment employees are considered as human resources.
  • Solution – Get the employees involved in the std setting process, Should not punish people but let them learn, encourage goal congruence etc.

Benchmarking

Benchmarking is identifying the best practice. Whereby it could lead to the improvement of performance.
  • Internal Benchmarking
    An entity (department, manager, employee, or SBU) is compared with another entity within the same group
  • External Benchmarking
    An entity compared with another entity which is outside the group.

McDonaldisation

McDonalds & Similar organisations implementation (low variety, High Volume) and its success of standard costing in their operations is identifiable at 4 levels,
  • Calculability – Every meal identical and standardize
  • Control – Reduced Human Involvement.
  • Efficiency – Optimum Method of getting from one point to another.
  • Predictability – Same service in every outlet throughout the world.

Diagnostic reference group (DRG)
  • This is how the standards were developed and implemented within the healthcare industry.
  • Where patients were grouped based on similar medical conditions from each group.
  • A sample was taken and by studying the sample average treatment for each medical condition was established.
  • That average treatment is now taken as the standard.



Standard Costing & Performance Evaluation
The following data is to be used to answer the following questions

SW plc manufactures a product known as the TRD100 by mixing two materials. The standard material cost per unit of TRD100 is as follows:
                  Material X 12 litres @ £2.50 £30
                  Material Y 18 litres @ £3.00 £54

In October 2002, the actual mix used was 984 litres of X and 1,230 litres of Y. the actual output was 72 units of TRD 100.
  • The total material mix variance reported was nearest to
  • The total material yield variance reported was nearest to

Solution

Standard Costing & Performance Evaluation

Explain how the marketing function assists in nurturing a culture of market orientation through the organisation.

Solution

  • Knowledge
  • Example
  • Activity
Developments in Management Accounting.
The modern business environment

Traditional production processes
  • Jobbing Production – Customers require goods to be produced to their own specifications. Orgs engages in one off job.
  • Batch Production – Production carried out in lots/batch production activity. The cost accumulated is for a number of similar units.
  • Mass Production – Standard product is in continuous production. This focuses on low unit costs.

1. The New Manufacturing techniques
  • Computer aided design(CAD) $ndash; Usage of high levels of computer technology to design products develop in comparison to the traditional using of drawing boards by organisations.
    Management Accountant needs to modify or develop new accounting methods.
  • Computer aided manufacturing (CAM) – Using of computer based technologies and machinery for production.
    This will result in the changing of the whole cost structure, thus, requiring developments in management accounting
  • Flexible manufacturing system (FMS) – Ability to produce a number of different types of products in the same premises with high levels of duration or technology by changing the machine settings quickly from one job to another.
    Management accountants are looking at better techniques to handle cost.
  • Computer integrated manufacturing (CIM) – The extension and long term direction of AMT in the production environment is known as CIM. AMT is for advanced technology users. That is, the organisations who use, CAD, CAM, FMS, EDI & any other advance technologies.
    Management accountants needs to develop methods to handle environments with such advance technologies.

Political & Social Accounting

This focuses on the manner in which an organisation carries out its work considering the society. Social accounting focuses on communicating the social & environmental effects of organisations economic actions to particular interest groups within society & to society at large.


Value chain

The success of the usage of AMT would depend on the thorough appreciation of the relationships between all the factors within the value chain.
  • R & D – Generating and experimenting with new ideas for products, services or process.
  • Design – The planning and engineering of products, services or processes.
  • Marketing – The process where potential customers learn about & value the attributes of the orgs.
  • Distribution – mechanism of delivering the products or services.
  • Customer Service – support services.




2. Production Operating Systems & Management Strategies

Materials requirement planning (MRP 1) – Traditionally raw materials were planned & purchased using the two bin system method or the system of stock control levels method. Both these methods were based on past usage & not on future requirements. So in the late 1960s a computer programme was developed, whereby the Planning for future Material & other Components was made easy. For a successful operation of MRP strict schedule adherence & accurate data is expected.

Manufacturing resource planning (MRP 2) – MRP 1 was later developed to a handle and plan other manufacturing resources such as labour hrs & machine hrs & even working capital.

Optimised production technology (OPT) – MRP could only plan for manufacturing resources & was not equipped to handle manufacturing process problems. Thus, a new computer programme system was developed to handle production process problems (bottlenecks/constraints) & develop solutions this was referred to as OPT. So OPT is based on "Theory of Constraints" with the objectivity of maximising throughput.

Enterprise resource planning/ technology (ERP/T) – MRPs & OPT looks at the manufacturing department or production department. But for modern organisations it is important that each & every part of the organisation is integrated into one planning mechanism. such integrated planning through the usage of complicated computerized systems is known as ERP/T.

Customer relationship management (CRM) – The system which contains all the information about the customers and customer requirements.

Supply chain management (SCM) – This focuses beyond individual companies, where it integrates the flow of information between different companies on a supply chain.



3. Total Quality Management (TQM)
  • Everyone in the organisation is in the continual effort to improve quality and achieve customer satisfaction.
  • Traditionally quality was checked by certain designated employees. This was known as quality control. The modern idea is that everyone in the organisation should get involved in delivering quality which is known as quality management.

Achievements of TQM depends on the following, (elements of TQM)
  • First in class quality (get it right the first time) – in traditional manufacturing defective products are a common occurrence, but to achieve TQM an organisation & its employees needs to make defective products a rare occurrence. The idea should be highest quality as possible.
  • Continuous improvement – Quality is multi dimensional (durability, functionality, colour, size & so on) so by only improving one part of quality, total quality is not achievable. So to achieve TQM organisation needs to continuously improve (Kaizen)
  • Competitive Benchmarking – quality is a relative expression, so for any company to be a total quality provider, they need to identify the competitors level of quality. So the products produced by the company needs to exceed the quality levels of others. Getting the quality information of competitors is known as competitive benchmarking.
  • Employee empowerment & Team Work - Quality is not something that can be achieved everyday through supervision. Workers need to have their own decision making power so that they deliver quality continuously & would also take their own initiatives to improve quality. Additionally total quality is only achievable through team work.
  • Supplier Quality – To achieve quality it is important that organisations ensure that the items supplied by the suppliers are of highest quality. TQM is not all about inside organisation quality. This is because if the inputs supplied are of low quality then whatever level of quality that is available within the organisation is of no use, because the quality of the output is likely to be less.


With quality there are four main types of costs
  1. Prevention costs – cost incurred to prevent quality problems. (training workers, updating machines, buying new machines or even establishing long term relationships with suppliers)
  2. Appraisal costs. – Cost incurred in checking quality. (salaries & others costs incurred as for the quality control department)
  3. Internal Failure costs – if a product is recognised as defective before being sold to the customer, any disposals cost or rework cost is knows as internal failure costs.
  4. External Failure costs. – if a defective product is sold to a customer the loss of good will, warranty costs or legal costs is known as external failure costs.

4. World Class Manufacturing
  • This is a term used to describe the manufacturing of high quality products, reaching customers quickly, at a low cost, providing high performance and customer satisfaction.
  • For such companies management accountants needs to provide world class information in order to maintain their position.

5. Synchronous Manufacturing
  • This is a manufacturing philosophy which aims at ensuring that all operations within an organisation are performed for the common good of the organisation & that nothing is done unless it improves the bottom line (profit).
  • Organisations need to firstly look at the production process & identify the bottlenecks & then the whole production process, now needs to be planned based on that bottleneck. (Drum) in front of the bottlenecks as well as where ever required inventory amounts should be kept in order to get the best out of the resources. (Buffer) Additionally to prevent unnecessary inventories there should be good communication (Rope) between bottlenecks & non bottlenecks.
  • Synchronous Manufacturing can be summarised as follows,
    • Detailed analysis of the plant's capabilities and the manufacturing environment with the aim of identifying the systems constraints – DRUM.
    • Buffers are then built into the system at strategic points throughout the plant so as to avoid disruption & ensure that the planned production schedule is met. – BUFFER.
    • A good communication network between the processes. – ROPE.
      A system of Drum, Buffer & Rope concept.


Theory Of Constraints.(TOC)
  • Organisations in their day to day operations face bottleneck & non-bottleneck resources. The process of maximising operating profit when faced with bottleneck and non bottleneck resources is known as TOC.
  • Bottleneck is a machine, a department, a team or an employee whose capacity limits the organisations operational flow.
  • Non bottleneck is a machine, a department, a team or an employee whose capacity facilitates the organisations operational flow
  • TOC involves 5 steps as guidelines to maximising operating profit when faced with bottlenecks & non bottlenecks
  1. Identify the organisations bottlenecks and non bottlenecks – There are number of ways to identify bottlenecks & non bottlenecks. For example, visually (managing by walking around) or through a calculation (by dividing the requirement from the availability) or through a proper investigation.
  2. Determine the production schedule for the bottleneck resources, that is plan for bottlenecks.(short term measure) – The organisation needs to decide the best product out of the bottleneck resource in order to mazimise profit. There are number of options available to identify the best product or products. For example, profit of each product or contribution per limiting factor or market sentiments.
  3. Determine the production schedule for the non bottleneck resources, that is plan for non bottlenecks in order to prevent unnecessary inventory.
  4. Take actions to remove bottlenecks.(long term) – There are number of options available, buy a new machine, upgrade the existing machines, train employees, recruit new employees & so on.
  5. Repeat the above steps. (Continuous Improvement.)

As per the accounting techniques developed for step 01 & 02 there are number of calculations involved.

Identifying bottlenecks and non bottlenecks.

            1. Resource Utilisation Rate.                                                   2. Maximum Production Units.
               Resource (HRS) required                                                Total Time Available for a Resource
                Res. (HRS) Available                                                             Per product time required


Plan for bottlenecks.

Throughput Accounting.
  • Throughput is an accounting method where profit maximising products are recognized out of the given bottleneck using a measure called throughput. Throughput is referred to as value added or returns.
  • Throughput accounting is similar to contribution per limiting factor calculation, which normally contains 3 main calculations,
    1. Contribution of each product.

      SP - VC (VC = DM + DL - V. O/H)

    2. Calculate contribution per limiting factor under each product.

                          Cost         
                   Limiting factor

    3. Rank the product based on the calculated contribution per limiting factor

  • Under throughput, the ranking is done under two measures.
  1. Throughput per bottleneck time period is calculated in order to identify the best product out of the bottleneck resource. it is calculated as follows,

    Throughput per Bottleneck Time Period =               SP – DM               
                                                                 Time on Bottleneck Resource


  2. Throughput calculation ignores other costs, such as O/Hs & labour which are essential in getting the materials converted to FGs. So there was a new measure that was developed, by taking the first measure & other cost amounts together called TA ratio. it is calculated as follows,

    Through Accounting Ratio (TA) =          Through Per Bottleneck Time Period           
                                                Conversion cost per time period (bottleneck)

                                              =              (Sales – DM costs) per time period      
                                                         (Labour + O/Hs) per time period


Current Effectiveness Ratio

Standard Minutes of throughput achieved
Minutes Available


This will measure effectiveness & compares it to a current std.


Backflush Accounting/Costing
  • In traditional manufacturing there are a number of departments, with a number of supervisors, specialised workers and high levels of inventories.
  • JIT resulted in the reduction of inventories so inventory valuation became irrelevant. Hence simplified procedures were adopted for allocation. This simplified method is referred to as backflush costing.
  • In modern manufacturing the whole production process is undertaken at one place. So in rapid time raw materials are converted to FGs.
  • So sequential tracking is now difficult where the only option available is to take the FG produced and work backwards (backflush comes with the idea that by looking backwards we are flushing the cost.) plus with lower levels of inventory, inventory valuation is also not very important under JIT.
  • Backflush Accounting can be identified with a number of points,

    1. Material & Conversion Cost are recorded when incurred based on their actual figures.
    2. Material & conversion cost are applied to products based on standard cost
    3. Any difference in the conversion cost a/c is taken to the cost of Goods sold account. (any difference in material a/c is taken forward)
    4. Entries are made with certain situations.(trigger Point),
      • With materials purchased.
      • With items completed or manufactured

Two methods involving backflush costing,
  1. Both trigger points are used where the organisation is a traditional purchaser, but JIT manufacturer or producer with the two situations, with adequate time gap two entries are separately made.(RM a/c is there)
  2. Only one trigger point is used, with the organisation involved in 100% JIT with no time gap between purchased and production. (No RM a/c)

Just In Time Concept

  • JIT is all about required items at required quality and required quantity delivered within the promise and precise time available. Goals of JIT
  1. Eliminate non value adding activities – in traditional manufacturing with high levels of FG inventories most organisations consume lot of time in non value adding activities. (example, purchasing time, inspection time, warehousing time & so on). But if the organisation is to transform itself in to JIT orders need to be delivered just in time & the only time available is for value adding activities. (purchasing time)
  2. Zero defects – In a JIT environment to deliver items as for the promise time, organisation needs to eliminate defects, because defective units delays the delivery day. To reduce the defects organisations normally follows an idea or a philosophy called TQM.
  3. Zero breakdowns – Ti deliver JIT all machines need to work properly. to ensure that all machines work properly, when there are no orders, multi skilled workers are to engage in 'Preventing Maintenance' ensuring that when the machines are operated they are in good working conditions. Thus, specialised workers needs to be trained to be multi skilled
  4. Zero Inventory – In a JIT environment with the production & purchasing based on JIT & processing undertaken at one place technically their cannot be inventories. But for a traditional organisation to be a modern organisation, elimination of inventories might be too extreme, whereas, minimising the inventories might be much more realistic.
    RMs can be reduced by having few reliable suppliers & engaging in long term relationships. WIP can also be reduced by having a notice board system or a signalling system, where a process will only start production if the other processes require items. This is called 'KanBan'. FGs can also be reduced through good communication links maintained with the customers
  5. 100% on time delivery - In JIT it is important that items are delivered at the promise time.
  6. Batch Size of one - JIT production or purchase is started with customer orders, so it is customised production & not standardised production. Customised production is identified as batch size of one.
  • JIT Production.
    Production planning is started only with orders received. (Production is demand – pull)
  • JIT Purchasing.
    Purchasing is only undertaken with the commencement of production planning. (Purchase is matched to the usage)
Developments in Management Accounting.
A company produces three products using three different machines. The following data is available for the latest period.

Machine hours required Product L Hrs per unit Product M Hrs per unit Product N Hrs per unit
Mixing machine 2 5 3
Cutting machine 3 4 2
Finishing machine 1 2 2
Sales demand 2700 units 1200 units 2500 units

Maximum capacity is as follows. (Hours Available)
  • Mixing machine       22,000
  • Cutting machine       15,400
  • Finishing machine       7,300

Required,
1.Identify the resource requirements for each machine.
2.Calculate resources utilization rate for each machine.

Solution

Standard Costing & Performance Evaluation

Explain how the marketing function assists in nurturing a culture of market orientation through the organisation.

Solution

Section Summary
General Information about Section 1

Weighting 30%
Total no. of sub sections 5
The most tested subsection 1.2
Last tested session May 2011
Number of sessions in assessment 7
Total number of questions tested so far 20


Tested Sequence


Syllabus Area No of Questions
1.1 3
1.2 1
1.3 8
1.4 3
1.5 5
Total 20


Possible links with other syllabus sections




"Must Study" Areas


1.3 The Theory and Practice of Standard Costing

1.5 Developments in Management Accounting

  • Knowledge
  • Example
  • Activity
The Nature & Purpose of a Budget
Budgeting
  • A budget is a pre determined estimate for a future period in total terms. It can also be identified as a quantified plan of action relating to a given period of time.
  • Multiple Functions of a budget,
    • Planning annual operations
    • Controlling activities
    • Communication plans to the various responsibility managers
    • Co-ordination the activities of the various parts of the organisations & ensuring that the parts are in harmony with each other
    • Motivation of managers to strive to achieve the organisational goals
    • Performance Evaluation of managers

  • If the budget is to be controlled effectively the management would have to receive information on a regular basis, to base their decisions on, the report should normally have the following characteristics;
    • Timely.
    • Accurate.
    • Communicated to the relevant manager.
    • Relevant to the recipient.

  • Strategic Planning – Preparing Long Term action plans to attain the organizations objectives.
  • Budgetary Planning – Preparing short to medium term plans. These are a breakdown of the organizations long term objectives.
  • Operational Planning – Preparing the day to day (short term) plans of the orgganisation. This will assist in the budgetary plan there by helping to achieve the strategic plans.
  • Budget Period – The time for which a budget is prepared. Normally 1 year.
  • Budget Interval – Splitting the budget in order to exercise control. That is 3 month's intervals or maybe 1 month's intervals
  • Budget Committee – This is the co-ordination body in the preparation and administration of budgets.
  • Budget Manual – This is a collection of documents that contains key information for those involved in the budgeting planning process

Budget Centre
  • CIMA defines it as "A section of an entity for which control maybe exercised through prepared budgets"
  • Each centre will have its own manager & he is responsible for managing & controlling the centre according to the budget.

Budgetary Control
  • Keeping the actual under the planned outcomes (budgets) through continuous comparison.
  • Costs are higher or revenues are lower than the budget – Adverse Variance.
  • Costs are lower or revenues are higher than the budget – Favourable Variance.

Using spreadsheets in budget preparation
  • Budget planning is a repetitive process; hence it might be helpful for a company to prepare its budgets using help from IT; a spreadsheet would help a company prepare the budget with ease.
  • It is important to identify the principal budget factor which limits the activities of the organisation this factor's budget should be prepared first.

Approaches to budgeting
  • Top Down approach (imposed budgeting) - Top management prepares the budget with little or no input from operating personnel. This method is suitable for newly established organisations, small & medium scale organisations & even for organisations who are facing problems.
  • Bottom-Up-budgeting (Participative Budgeting) – Budget holders are given the opportunity to participate in setting their own budgets. This method is suitable for large decentralised organisations as well as for multinationals.
  • Negotiated budget – budget set largely on the basis of negotiations between budget holders & those to whom they report.

Alternative approaches to budgeting
  • Traditional or Incremental budgeting - Traditional approach to budgeting is to base the next year's budget on the current year's results plus an extra amount for estimated growth on inflation next year.

    Current years result is recognised by comparing the current budget with the current actual. So the incremental budget is an addition to the current situation. Where at least the current performance is maintained in future, but the problem is current inefficiencies are taken forward

  • Rolling budgeting – A budget continuously updated by adding a further accounting period (month or quarter) when the earliest accounting period has expired.,

    The idea behind rolling budget is for a fixed period. Where when a particular period is over an equal period is added from the future, additionally, organisation is also in a position to revise their existing periods as for the budget.

  • Zero – Based Budgeting.(ZBB) – All the activities are to be justified & prioritized before resources are allocated to each activity. ZBB states that projected expenditure for existing programmes start from base zero. ZBB is normally prepared for the items & activities which changes from one year to another (Discretionary Costs).

Steps in ZBB – How to implement.
  1. Possible Options recognized. (Decision Packages)
    Any implementation of ZBB requires an organisation to identify possible options available in performing a particular activity. Example; R & D department, There are number of options available, in-house, outsource & collaboration with universities. Additionally under the main options there can be sub options. Example; in-house 2 senior researhcers & 4 Juniors.
  2. Each option is evaluated & Ranked.(Cost/Benefit Analysis)
    Once the option is recognised for each option the organisation needs to forecast cost as well as benefit & do a cost benefit analysis. based on the analysis decision packages should be ranked
  3. Resources are allocated based on the best option.(Budgets prepared)
    The best decision package is now selected & the budget is prepared based on that.

Advantages of ZBB
  1. Avoid complacency associated with traditional incremental approach.
  2. Focuses its attention not only on costs but on benefits provided.
  3. Preparing of decision packages will provide opportunities for the involvement of the employees, providing job satisfaction & also provides useful ideas.

Disadvantages of ZBB,
  1. Ranking process is difficult as value judgments are inevitable; this is a major issue in the public sector.
  2. The work involved in the creation of decision packages & subsequent ranking for the top management is very considerable.
The Nature & Purpose of a Budget
A company produces three products using three different machines. The following data is available for the latest period.

Machine hours required Product L Hrs per unit Product M Hrs per unit Product N Hrs per unit
Mixing machine 2 5 3
Cutting machine 3 4 2
Finishing machine 1 2 2
Sales demand 2700 units 1200 units 2500 units

Maximum capacity is as follows. (Hours Available)
  • Mixing machine       22,000
  • Cutting machine       15,400
  • Finishing machine       7,300

Required,
1.Identify the resource requirements for each machine.
2.Calculate resources utilization rate for each machine.

Solution

The Nature & Purpose of a Budget

AZ is a not-for-profit charity organisation which is funded by public donations, has revealed that it is not making the best use of its available funds. It has carried out a review of its budgeting system and is considering replacing the current system with a zero-based budgeting system.
Explain the potential advantages and disadvantages for the charity of a zero-based budgeting system.

Solution

  • Knowledge
  • Example
  • Activity
Budgetary Preparation
  • This normally starts by identifying the key limiting factor. From organisation to organisation the key limiting factor might be different, for example, sales demand, skilled labour, machine capacity, specialised material & so on. Budgets can be divided into 3 main types.

Functional Budget

Sales Budget

Product A/Period 1 Product B/Period 2
Units.    
Sales Price.    
Sales Value.



Production Budget

Product A/Period 1 Product B/Period 2
Sales units (Sales Budget)    
Less – Opening Stock (FG)    
Add – Closing Stock (FG)
Production Units



Material Usage Budget

Material X/ Period1 Material Y/ Period2
Production Units (Production Budget)    
Per unit requirement    
Total requirement(units)
Rate per unit of material
Total Cost



Material Purchase Budget

Material X/ Period1 Material Y/ Period2
Production Requirement (Material Usage Budget)    
Less – Opening Stock(RM)    
Add –Closing Stock (RM)
Total Purchase(units)
Rate per unit of material
Total Cost



Labour Budget.

Labour S/ Period 1 Labour US/ Period 2
Production Units (Production Budget)    
Per unit requirement (HRS)    
Total Requirement(HRS)
Rate Per Hr
Total Cost



Production Cost Budget.

Product A/Period 1 Product B/Period 2
Material Usage Budget    
Labour Budget    
Variable O/H
Fixed O'H
Total Cost



Cash Budget

Period 1(?) Period 2 (?)
Cash Receipts;    
Cash Payments;    
Net Cashflow (receipts- payments)
Opening Balance
Closing Balance

  • This will show the cash effect of all the decisions taken.
  • This will provide information for managing, with regarding to the position of the company's cash. Hence potential problems that could arise with regard to cash could be avoided.
  • Allowances must be kept for bad & doubtful debts.
  • Depreciation is not included.
  • Cash Flow forecasts are vital for the management of cash.


Master Budget.

A summary budget & normally contains a budgeted profit or loss account, a budgetary balance sheet & budgeted cash flow statement



Budgetary Preparation
Budgetary Preparation
  • Knowledge
  • Example
  • Activity
Forecasting & Planning.
  • The previously prepared budgets were all about getting the future figures organised. Before organising the future figures, organizsations need to generate future figures (Forecasting).
  • Past information is used to get the future figures, where the fundamental assumption is that the past will provide guidance for the future. There are 2 main techniques that can be considered for forecasting purposes,

Regression
  • Regression involves finding out the relationship of 2 variables, namely the dependent variable (Y) and independent variable (x) and forecasting is done by extending it to the future period (extrapolate) in order to get the forecast.
  • There are 2 methods of getting the dependent & independent variable.
  1. Scatter Diagram Method - Past information as for dependant and independent are plotted on a graph, where a line of best fit is identified. Once the line of best fit is recognised it is extended to get the forecast.
  2. Linear Regression or Least Square Method Of Regression - The line of best fir in the scatter diagram is subjective. So a mathematical formula is used to establish the line of best fit which is,
                y = a + bx

Time Series.
  • This is a series of figures or values recorded over time (Ex; Monthly sales over 5 yrs.) Time series is a technique where in order to get the forecasted figures past information is looked at and by understanding what had happened in the past future forecasting is made.
  • Movements in the past are mainly determined by 4 reasons,

    1. Trend. (T) – Underlying long term movements over time, with the information observed.
    2. Seasonal Variation(S) – Short term fluctuations in past information which are normally there every year, every month, or even every day.
    3. Cyclical Variations(C) – Medium term movements with past information. For Example economic growths as well as economic decline are not continuous situations. Normally growth is there for few years followed by few years of decline & then again growth, meaning medium term changes repeats themselves.
    4. Random Variations(R) – When looking at past information there are sudden movements which are normally due to unforeseen reasons.

  • In practice only Trend & Seasonal factors are undertaken for forecasting,

    • Additive Model                                                      Multiplicative Model.
       Y = T + S                                                                    Y = T x S        

    • Random Variables are unforeseen, hence difficult to predict.
    • Cyclical Variations through the history show no proper relationship.

  • So for forecasting purposes, due to practical problems random & cyclical variations are assumed to be negligible.

Finding the Trend (T)
  • The best way to identify the trend is to takeout other changes by taking an average, but the average taken is a continuous average and is known as a "moving average"
  • An alternative method of getting the trend is through an established regression formula.
            Y = a+bX
  • Additive or Multiplicative as long as it's the same information Trend should be the same

Finding the Seasonal Variance(S)
  • Additive Model, S=Y–T
  • Multiplicative Model, S=Y/T

Once the Trend & Seasonal Factors are established forecasting requires 2 steps,

Step 01 – Identified Trend is extended to future. (Extrapolate)

Step 02 – Once the forecasted trend is identified, it is seasonalised but it depends on the time series model, being used by the orgs.



Sensitivity Analysis
  • There is always an element of uncertainty associated with budgets; hence it is important that the uncertainty is recorded in some way possible. There are many ways available for recording purposes, but the most commonly used method is a sensitivity analysis.
  • Under the above method a series of 'what if' questions are looked at, such as, what if the sales quantity changes? What if the sales price changes? What if the material cost changes? So now the organisation posses' information for possible changes. This will enable the organisation to better handle the uncertainty.
Forecasting & Planning.
PMF plc is a long established public transport operator that provides a commuter transit link between an airport & the centre of a large city. The following data has been taken from the sales records of PMF plc for the last two years;

Quarter Number of passengers carried
Year 1 Year 2
1 15,620 34,100
2 15,640 29,920
3 16,950 29,550
4 34,840 56,680

The trend equation for the number of passengers carried has been found to be,
x = 10,000 + 4,200q
Where x = number of passengers carried per quarter.
& q = time period(Yr1 quarter 1:q = 1)
                           (Yr 1 quarter 2:q = 2)
                           (Yr 2 quarter 1:q = 5)
Required,
  1. Calculate the trend for each of the quarters under year 1 & year 2.
  2. Calculate the seasonal factor for each of the quarter if the additive model is used & if the multiplicative model is used.
  3. Using the trend equation for the number of passengers carried & the multiplicative time series model, determine the expected number of passengers to be carried in the third quarter of year 3
Solution

J plc uses time series analysis and regression techniques to identify future sales demand. It has derived the following trend formula using above techniques:
                y = 200x + 4,800

Where y is the total sales units for a period and x is the quarterly period number.
The seasonal variation index values on past data are:
Quarter 1           110%
Quarter 2           95%
Quarter 3           92%
Quarter 4           112%

The increase in budgeted sales volumes between quarter 1 and quarter 2 next year, which are periods 12 and 13, will be:
  1. 890 units
  2. 200 units
  3. 100 units
  4. 720 units
Solution

  • Knowledge
  • Example
  • Activity
Programme Planning Budgeting System. (PPBS)
Programme Planning Budgeting System

  • When organisations are preparing budgets the main motive is profit, for which sales demand, production units, materials & labour is used.
          But
  • When a not for profit organisation is preparing their budgets the above factors are not available or are different.

    Example; sales demand is replaced with serving people in need. Production is replaced with providing services. Purchased material is replaced with donated material. Paid labour is replaced with volunteered labour.
          So
  • With most of the items taken to prepare normal budgets not available, not for profit orgsanisations requires an alternative method of budgeting. This is commonly known as Programme Planning Budgeting System. (PPBS)
  • teps to prepare an alternative budget,

    Step 01

    Review Long Term Objectives – for starters non for profit organisations firstly need to recognise & review their long term objectives.


    Example; If save the Children Fund is planning its budget, then the starting point would be is to recognise their long term objectives (goals) such as,
    • Educate children
    • Feed children or even health care of children


    Step 02

    Identify Possible Programmes. (Options or Decision Packages) – once the objectives are developed the organisation needs to develop possible options of achieving those objectives

    Example; for educate children objective, possible options would be,
    Support the existing education system (provide text books, funds for teachers training & so on)
    Create an effective after school education system

    Step 03

    Evaluate the programmes (Cost/Benefit analysis) & select the most appropriate – Once the programmes are realised the organisation needs to analyse the cost benefit situation of each programme, and based on the cost benefit analysis, ranking should be done & then the budget prepared based on the best ranking, this allows non for profit organisations to prepare their budgets

    Step 04

    Continue the analyse the selected programmes (step 03)


    PPBS is suitable not only for NGOs but for government organisations such as schools and hospitals.

Activity Based Budgeting (ABB)
  • Traditional budgets were based on inputs where as ABB is based on forecasted output. That is the activities required as well as the resources for those activities.
  • ABB is also in more detail

Not for Profit sector (NFP)
  • NFPs are not primarily motivated by profit, but their objectives would be partly,
    • Legislated
    • Constitutionalist
    • Political

  • Objectives may be vague & may change over a regular time period.
  • Efficiency – Getting the maximum possible use of the given resources. Comparing the input & output.
  • Effectiveness – Finding the cheapest method to achieve an objective.
Programme Planning Budgeting System. (PPBS)
Programme Planning Budgeting System. (PPBS)
Identify the steps involved in preparing a budget for a non for profit organisation.
Solution

  • Knowledge
  • Example
  • Activity
Budgetary Control
Fixed & Flexible Budgets
  • When performing budgetary controls, the biggest problem is the original budget prepared and the actual information available are now based on 2 different activity levels.
  • In order to make a meaningful comparison the original budget (Fixed Budget) is amended which is called flexible budget.

Flexed Budget is mainly prepared under 2 methods,


1. Traditional
  • Flexed budget is prepared by taking into account only one reason.
  • O/Hs normally contain fixed as well as a variable component. These 2 are isolated using the Hi Lo method.

Budgeted Rate x Actual Activity Level


2. ABC
  • Flexible budget is prepared by looking at each item separately and flexed using their own reasons

Bud. Cost Per Driver x Act. No. Of Driver

Budgetary Control
AZ plc is preparing its maintenance budget. The number of machine hours and maintenance cost for the past 6 month are given below:

Month Machine hours £
1 5,224 18,284
2 6,110 20,491
3 4,302 16,348
4 4,846 17,445
5 4,257 16,600
6 5,068 17,832

Calculate the budget cost allowance for an activity level of 5,112 machine hours, before adjusting for any price changes.
  • 18,400
  • £23,500
  • £17,980
  • £17,960

Budgetary Control
Define flexible budget
Solution

Section Summary
General Information about Section 1


Weighting 10%
Total no. of sub sections 5
The most tested subsection 2.1
Last tested session May 2011
Number of sessions in assessment 7
Total number of questions tested so far 19


Tested Sequence


Syllabus Area No of Questions
2.1 8
2.2 6
2.3 3
2.4 1
2.5 1
Total 19


Possible links with other syllabus sections




"Must Study" Areas


2.1 The Nature and Purpose of a Budget

2.2 Budgetary Preparation

  • Knowledge
  • Example
  • Activity
Capital Budgeting & Project Appraisal

Why an Investment?
  • Start a new business.
  • Replace the existing asset.
  • Expand the capacity of the existing asset.
  • Modernization.
  • Diversify.

Capital Budget
  • The process of generating funds, evaluating& selecting projects & following upon capital expenditure.
  • Capital expenditure is an investment that generates benefits over a period of 12 months

Investment Appraisal Techniques

1. Accounting Rate of Return. (ARR)
  • ARR uses accounting profits to appraise the investment.
  • It's also referred to as ROCE.
ARR =   Avg Annual PBIT     X 100
Initial / Avg Investment

Avg =  Starting Inv / NBV + ending Inv / NBV Investment 
2

Strengths,
  1. Easy to understand & interpret.
  2. Since profits are used it is more comfortable for the accountants.
Drawbacks,
  1. Ignores the time value of money.
  2. Profits can be manipulated.
  3. Does not consider the length of the project & how fast it recovers the initial investment.

2. Payback Period (PB)
  • Time that it takes to repay back the investment in a project.
  • Expressed in years.
  • Uses cash flows.
Target Payback Period is estimated based on the,
  • Historical Trends.
  • Type of Project & Industry & the level of Risk.
  • Company Objectives & Shareholder expectations.
Payback Period  = Last Full Yr +   Balance Req. to Recover  
                                               Cash Inflow of the PB Yr.

Strengths,
  1. Easy to understand.
  2. Less room for manipulation.
  3. Identifies the time taken to recover the investment.
Drawbacks,
  1. Ignores the time value of money.
  2. Accept projects which are not viable.
  3. Reject projects which are viable, bias towards the Short Term.
Only operational cash flows should be considered when calculating the payback period. Scrap value, capital investment, working capital investment should not be considered


3. Discounted Payback Period (DPB)
  • Time period taken to repay back the cash flows in PV terms.
  • DPB incorporates the Time Value of Money

Concept of Time Value of Money

An investor would look for a reward for the following,
  1. Reward for Inflation.
  2. Reward for Risk.
  3. Reward for Patience
The total expected return of an investor will be calculated as follows,

1+Total Expected = (1+ Reward for) x (1+ Reward for) x (1+ Reward)
   Return                    Inflation                  Risk                 Patience

The total expected return by an investor will be equal to the cost of capital of the project / company.


Future Value vs Present Value

FV = PV (1+r) n

Example: Calculate the FV of £10,000 in 5 yrs time if the cost of capital is 10%

FV = PV (1+r) n
FV = 10,000 (1+10%) 5
FV = 16,105.10

Discounted Cash Flow Factor (DCF Factor)

DCF = (1+r) ‐n


An Annuity
  • This is a constant cash flow which is spread over a definite time period.
PV of an annuity = constant cash flow x annuity factor.

Example: Calculate the PV of a constant cash flow of £12,000 spread over a 5 year period if the cost of capital is 12%

PV of an annuity = constant cash flow x annuity factor.
                          = 12,000 * 3.605
                          = £43,260


A Perpetuity
  • This is a constant cash flow spread over an indefinite time period.
PV of a Perpetuity = Constant Cash Flow
                                Discount Rate

Example: CA constant cash flow of 800 is expected to be spread over an indefinite time period. The cost of capital is 8% identify the PV of the cash flows,

PV of a Perpetuity = Constant Cash Flow = 800 = £10,000
                               Discount Rate           0.08


4. Net Present Value (NPV)
  • The net value of all cash inflows & outflows in present value terms.
  • Steps of NPV,
    • Forecast the future cash flows.
    • Identify an appropriate discount rate (cost of capital) & discount cash flows.
    • Compare cash inflows & outflows in PV terms.

Relevant costs & Cash flows for NPV

Relevant cost is a future cash flow item. A relevant cash flow for an investment decision would be incremental or avoidable as result of the decision to be made.



5. Internal Rate of Return(IRR)
  • The actual or implied rate of return earned from a project.
  • IRR is the rate of return at which NPV = 0
Where;
a = lower discount rate
b = higher discount rate
c = NPV @ the lower discount rate
d = NPV @ the higher discount rate

IRR =  a + [ (b-a) x     A     ]
                             (A - B)


NPV vs IRR
  • When selecting the best project out of 2 mutually exclusive projects, the NPV & IRR could provide contradicting conclusions. NPV technique assumes that future cash flows earned from the project would be reinvested back at the COC. IRR technique assumes that future cash flows earned from the project would be reinvested at the IRR itself. Therefore it can be concluded that the assumption of reinvesting the cash flows at the cost of capital is more realistic compared to the assumption of reinvesting them at the IRR.

Drawbacks of IRR
  • The reinvestment assumption as stated above. – can overcome by using Modified IRR
  • The other drawback is IRR expects cash flows to follow a conventional pattern. – can overcome by using Multiple IRR

Modified IRR (MIRR)
  • This revises the original IRR to accommodate a more of a lower return for future cash flows.

Steps of MIRR
  1. Convert all future cash flows of the project to the values as at the end of the project, using an appropriate reinvestment rate.
  2. Identify the net return of the project by comparing the PV & FV of these cash flows.

Multiple IRR,
  • When a cash flow changes its direction from negative to a positive more than once (Non conventional cash flow), there is more than one IRR, this is referred to as multiple IRR. Therefore such cash flows would have more than one cost of capital at which the NPV becomes 0. (When a cash flow changes its direction from negative to a positive only once, then, such cash flows are referred to as conventional cash flows. There is only one IRR.)
  • When non conventional cash flow patterns exist multiple IRRs should be observed after drawing a graph between NPV & COC

Drawbacks of NPV
  1. At the start of the project an additional investment is required in the form of working capital. This is ignored.
  2. The impact of inflation has not been taken into consideration when forecasting the future cash flows.
  3. The effect of taxation has been ignored.
  4. All projects may not have an equal life, therefore when selecting the best project out of the series of projects, with unequal lives; a specific comparable measure should be established.
  5. The issue of limited capital availability has not been recognised.
  6. The accuracy of the future cash flows is subjected to risk. Therefore we should look at the possibility of better managing the risk.
  7. It has been assumed that, the COC of the project would remain constant throughout the life of the project; however, the return expected by the capital providers would change time to time.



Capital Budgeting & Project Appraisal
A project requires an initial investment of £ 800,000 & then earns net cash flows as follows,
Maximum capacity is as follows. (Hours Available)
  • Mixing machine       22,000
  • Cutting machine       15,400
  • Finishing machine       7,300

Required,
1.Identify the resource requirements for each machine.
2.Calculate resources utilization rate for each machine.

Solution

Capital Budgeting & Project Appraisal
The data for project CC is given below. The Initial Investment is £2000. Calculate the NPV & IRR for the project CC.

Year    1       2       3       4   
CC £('000) 1280 1280 40 40
Solution

  • Knowledge
  • Example
  • Activity
Advanced Investment Appraisal
Investment Appraisal with Working Capital.
  • Investment in working capital is a temporary fund requirement to start the working capital cycle. (to buy raw materials, pay laborers etc.)
  • When the investment is made at the start of the project this amount should be recognised as a cash outflow.
  • However, the working capital investment could be recovered at the end of the project & therefore this amount should be recognised as a cash inflow during the final years of the project.

Investment Appraisal with Inflation.

Inflation will have two impacts on a project.
  1. The discount rate may include an allowance for inflation.
  2. The cash flows maybe subjected to inflation

Real Approach
  • When the projects are appraised excluding inflation, it is referred to as the real approach. Both cash flows and discount rates should be in real terms (Inflation excluded). As for the real approach, inflation is considered to be a "pass through item". Any impact on the cost dues to inflation is assumed to e fully reflected through an adjustment to the selling price.

Money Approach
  • A project could be appraised using inflation included discount rate & inflation included cash flow. This is referred to as money approach.



(1+ Money Rate) = (1 +Inflation) x (1+Real Rate)

Exam Note
  1. When one inflation rate is applicable in all cash flows, real approach is recommended.
  2. When different inflation rates are applicable on specific cash flows, money approach should be used.
  3. Normally discount rate should be assumed as money rate unless stated otherwise.

Investment Appraisal with Taxation.

There are two major effects on an investment due to taxation.

1. Additional profits from the project would give rise to an additional tax burden.

New Investment = Additional Profits = Additional Tax Liability = Tax Payment

2. The Capital investment would attract capital allowances. These capital allowances can be deducted when       arriving at the taxable profits. This will lead to a tax saving.

New Investment = Attract Capital Allowances = Taxable Profit will Reduce = Tax Liability Reduce = Tax Saving
Taxable Cash Flows           XX
(–) Capital Allowances        (X)
Taxable Profit                    XX

Impact of Capital Allowances towards the appraisal.
  1. The first allowance is assumed to be claimed in Year 1 unless stated otherwise.
  2. No written down allowance is available during the year of disposal.
  3. Normally discount rate should be assumed as money rate unless stated otherwise.
  • A project could be appraised using inflation included discount rate & inflation included cash flow. This is referred to as money approach.
  • If Sales Proceeds are greater than the tax written down value – Balancing Charge - This should be treated as an opposite version to an allowance; that is add on to the taxable cash flow when arriving at the taxable profit.

Payment of tax liability.
  • If the company is a small one, the tax liability will be settled one year later.
  • If the company is a large one, 50% of the tax liability would be paid in the current year and the balance 50% would be paid during the following year. (Follow the instructions as for the given question.)

Exam Note

Capital Investment, Scrap Value, Working Capital Investment should NOT be recognized when calculating the taxable cash flow


Investment Appraisal with Unequal lives.
  • Projects with unequal lives should be compared only after converting them into a common time frame. It is assumed that projects are repeatable with similar cash flow in the future.

Equivalent Annuity Value (EAV)
  • EAV is the annualised value of the project & it represents the constant annual value of the overall NPV of the project. So it can be used to compare between projects with different economic lives.
PV of an Annuity = Constant c / flow * Annuity factor
EAV = NPV of the project
             Annuity Factor


Replacement of Assets
  • When a company is making a decision on the replacement cycle of an asset, the concept of EAV should be used since each life cycle has a different life. In this we would only consider asset specific cash flows. Such as investment, disposal or second hand value, maintenance or repair cost of the asset.

Investment Appraisal with Capital Rationing.

  • Capital Rationing arises when the fund availability is less than the fund requirement.
    Project Divisibility
  • Divisible Projects – Whole project or any fraction of the project could be undertaken - PI (if a fraction of the project is undertaken, the investment & the cash flows would be apportioned proportionally)
  • Indivisible Projects – Either the whole project in full or not at all – Trial & Error.
  • Mutually Exclusive Projects – Only One Project at a time will be undertaken – Linear Programming (not examinable)

Profitability Index (PI)
  • This is used to rank the investments when the company is exposed to a capital restriction. PI is the NPV earned for one pound of investment.

PI = NPV of a project
         Investments


Post Completion Audit(PCA).

Investment Cycle



  • PCA is an important component of an investment cycle, since it updates the decision making on the most recent development. It monitors the actual progress of the projects and compares with the initial forecasts made to identify any variations.

Project Abandonment
  • A project should be abandoned if the NPV of the future cash flows turnout to be negative at any given time. The following c / flows would arise, Redundancy Payments, Proceeds from sale of assets & other penalties.

Advanced Investment Appraisal
The following information is available for proposal A. The investment life is 5 years.

Information £('000)
Capital expenditure (260)
Annual pre depreciation profits 70
Plant scrap value 40
Working capital required over the project life 50

Information Y0 Y1 Y2 Y3 Y4 Y5
Capital expenditure (260)                  
Annual pre depreciation profits          70 70 70 70 70
Plant scrap value              40
Working capital required over the project life (50)          50   
Advanced Investment Appraisal
Identify the benefits & drawbacks of a post completion audit.
Solution

Section Summary
General Information about Section 1


Weighting 25%
Total no. of sub sections 2
The most tested subsection 3.2
Last tested session May 2011
Number of sessions in assessment 7
Total number of questions tested so far


Tested Sequence


Syllabus Area No of Questions
3.1 3
3.2 7
Total 10


Possible links with other syllabus sections




"Must Study" Areas


3.1 Capital Budgeting & Project Appraisal

3.2 Advanced Investment Appraisal

  • Knowledge
  • Example
  • Activity
Investment Appraisal with Risk & Uncertainty

Risk
  • Risk can be defined as the possibility of having a range of possible outcomes that could be measured. If the outcome is known then there is no risk. In the investment world risk is the chance that an investments actual return would be different to what was originally expected
  • The risk can be measured using techniques such as standard deviation. Standard deviation represents the range of outcomes and therefore higher the standard deviation wider the range of possible outcomes & thus higher the risk would be.
  • The tourism industry is more exposed to risk compared to the healthcare industry. That is, the range of possible outcomes in Tourism Industry is relatively higher compared to the range of possible outcomes in the healthcare industry.

Uncertainty
  • This is a situation where, even the range of possible outcomes cannot be measured or estimated. Therefore uncertainty cannot be managed, where as risk can be managed.
Techniques of incorporating risk
  1. Sensitivity Analysis
  2. Probability Estimates and Expected Values
  3. Decision Tree Analysis
  4. Adjusting the Discount Rate
  5. Certainty Equivalent Method

1. Sensitivity Analysis
  • Sensitivity Analysis discusses the impact of the change in one variable towards the investment decision. Investor would ask "WHAT IF"
Sensitivity of a Variable =  NPV of the project    x 100
                            PV of the variable

Sensitivity of a variable; when compared between 2 viable projects

Sensitivity of a Variable =  NPV of best option – NPV of next best option     x 100
                            PV of the variable

Strengths of sensitivity analysis
  • The information would help identify the impact in one variable towards the investment decision.
  • Easy to understand & calculate

Drawbacks of sensitivity analysis
  • Only one variable can change at a time & therefore, it is assumed that all other variables would remain unchanged. However, in real life, more than one variable could change the same time.

2. Probability Estimates and Expected Values
  • Probability can be defined as the chance of one outcome materialising compared to the total possible outcomes

Expected Value (EV)
  • An expected value is calculated by multiplying the value of each possible outcome by the probability of that outcome & summarising the result.
  • Therefore expected value is probability weighted cash flow. EV rule;
    • EV is positive (+), Viable.
    • EV is negative (–), Not Viable.
    • Higher the EV better it is.

Drawback of Expected Value Concept
  1. If the most likely outcome does not materialise, the decision could become unfavourable. This is if the negative outcome materialises, the decision maker would be at a disadvantage.
  2. The accuracy of the probability estimates could be subjective.

3. Decision Tree Analysis
  • A decision tree can be drawn to represent decisions involving a number of events. It uses the concept of EV to solve the decision making problems in an uncertain environment

There are 2 main elements,

A Decision – A decision box is used to express various options available for a particular decision.

---image-----

An Uncertain Outcome – Decision Circle – Possible outcomes (uncertain outcome will be attached to probability estimates.)

---image-----

Guidelines,
  1. A decision tree should always start with a decision box.
  2. Normally a decision box cannot be followed by another decision box
  3. A decision box should be followed by an outcome circle.
  4. After each outcome circle you should ask the questions, " can I make another decision " or " is there another uncertain outcome"
    If the answer is yes = proceed in the decision tree
    If the answer is no = That concludes the decision tree

Value Of Perfect Information
  • When trying to increase the accuracy of these probability estimates one method that could be used is to conduct a market research. But, the market research would come at a cost. Therefore we need to estimate whether the company can afford the price of such information. This information & value is referred to as "value of perfect information"

4. Adjusting the Discount Rate
  • An additional risk premium can be incorporated to the discount rate when evaluating the projects. Therefore the risk inclusive cash flows could be discounted using risk inclusive discount rate. The risk premium could be varied to incorporate different levels of risk.
  • If the project is viable with a positive NPV, when discounted with the additional risk inclusive discount rate the company can decide to accept the project.

( 1 + Total Expected Return ) = ( 1 + Risk Premium ) x ( 1 + Risk Free Rate )


5. Certainty Equivalent Method
  • If the future cash flows are uncertain, the cash flow could be adjusted to eliminate the risk involved in the project. Therefore risk adjusted cash flows can be discounted using risk free discount rate.

Strengths of Certainty Equivalent Methods
  1. It helps to adjust the cash flows by specific values and understand the impact towards the appraisal.
  2. Identifies the impact of a change in a cash flow towards the investment decision.

Weaknesses of Certainty Equivalent Method
  1. High level of subjective judgment due to assumption in changing cash flows.
  2. Using the risk free rate to discount the cash flows may under estimate the cost of capital

6. Simulation,
  • In real life more than one variable change at the same time. Hence, techniques such as "Monte Carlo Simulation "would help us to change more than one variable at the same time & evaluate the impact on the investment decision.
Steps;

Step 01 – Identify the major variables.

Step 02 – Establish the relationship between these major variables & the NPV.

Step 03 – Identify possible outcomes for each variable & attach probability estimates for each outcome.

Step 04 – Assign a unique range of random numbers.

Step 05 – Generate random numbers using a computer.

Step 06 – Simulation process will calculate the NPV of the project based on the selected outcomes.


Maximin, Maximax & Regret Criteria


Maxmin Approach


This looks at the worst possible outcome → that is Bad → then the best outcome among the items → that is least worst outcome.


Maxmin Approach


Looks at the highest possible return → that is Good → Highest possible Profit.


Minimax Regret Approach


The decision is made today based on how the person might feel at the of tomorrow's market. Success of the market will depend on the conditions prevailing. The person might feel happy or else have a regret at the end of the market tomorrow.
Investment Appraisal with Risk & Uncertainty
Cash flows from a new investment venture may depend on whether a competitor decides to open up in the same area. We make the following estimates

Competitor opens up Probability Project - NPV
Yes 0.3 (10,000)
No 0.7 20,000

Calculate the expected NPV of the project & advise whether to invest or not.
Solution

Investment Appraisal with Risk & Uncertainty
The risk premium for X Ltd is 5% and the risk inclusive discount rate is 15.5%. Calculate the risk free rate.
Solution

  • Knowledge
  • Example
  • Activity
Managing Working Capital – Cash Flow.

Cash Management
  • Organisations will have to balance their financial activities between liquidity and profitability. (A good mix of both liquidity and profitability would ensure that the organisation is performing at its highest level)
  • Organisations look at not only generating cash but also making sure that the entity has cash at all times to pay the bills and expenses. It also looks at opportunities to invest the surplus cash.
  • There will be an opportunity cost involved on the holding of cash. This would be the profits that could have been made if the cash was invested.
  • So the theory cash management focuses on maximising the cash in the company & gaining interest on the additional funds which may not be used in the short run.
  • It is important to identify the cash requirements,
    • In order to minimize the finance cost
    • Maximise surplus returns
    • Avoid shame because of inability to make payments at an unexpected time.

  • Thus, it is important to have an efficient cash management. For this to take place sales debts should be collected and banked quickly. Payments owed should be delayed as much as possible.

Managing Cash Deficits
  • Organisations normally use the bank overdraft to overcome cash deficits. However, it is important that the company takes the necessary steps to avoid or delay the use of the bank overdraft. Following are some the steps an organisations can consider,
    • Delay the major payments of capital expenditure.
    • Fast track the collection period from debtors & delay the trade payables collection day.
    • Maintain a lower inventory level.
    • Delay payments of unnecessary items.
    • Have a mix of credit sales & cash sales.
    • Use equity capital rather than debt capital for financing.

Cash Float
  • This indicates the amount of cash tied up from the time the payment is initiated until the money is received.
Example; A student in Ireland pays the money to the bank and obtains a draft for £195 on 5th October which is sent to CIMA London. The money is realised on the 22nd of October which indicates that the £195 is tied up for 17days. Thus, an organisation will try to minimise the float.
  • Reasons for a lengthy float,
    • Lodgement Delay – Delay because of the time taken to deposit the money.
    • Clearing Delay - Delay caused by the banking system to make the funds available.
    • Transmission Delay - Delay caused by the mode of payment. (Sending a cheque via post) The use of electronic fund transfer systems will eliminate transmission delays. (Credit cards)

Sources of Short Term Financing

1. Trade Credit
  • This is the cheapest and most common method of short term financing.
  • The money owed to the suppliers of goods& services.
  • No cost for trade credit.

2. Overdrafts
  • The bank will allow a current account holder to issue cheques over & above the balance available.
  • The bank should authorise the overdraft facility.
  • Interest will be paid based on the actual amount used and not the facility.
  • The bank may or may not request assets to be provided as security.
  • The bank will have the right to recall the money at short notice.
  • It requires less documentation and it can be seen a flexible way of getting finance.

3. Term Loans
  • Term loans are loans offered by high street banks.
  • Money will be obtained for a specific time period.
  • Interest will be charged on the entire loan.
  • The interest rate can be fixed or floating (variable).
  • Rate of interest will be lower than the bank overdraft rate.
  • Organisations can negotiate the term loan for a reasonable time period.

4. Factoring
  • When a company sells good or service to customers they will have to wait for 30 to 60 days to receive the payment.
  • However, companies have to fund various requirements in order to ensure a smooth flow in the business.
  • Factoring organisations will help improve this process by advancing 80% to 85% of the value immediately and the balance once the money is recovered.
  • So factoring is the sale of debt to a 3rd party (Factor) at a discount in return of prompt cash.

5. Export Factoring
  • Similar to factoring used within the domestic trade.
  • But the sales invoice relating to foreign customers will be kept as security.
  • 80% to 85% of the value can be collected immediately.

6. Bills of Exchange
  • The organisations will sell on credit to a foreign customer and request the foreign customer to sign (accept) a document called bill of exchange.
  • The accepted bill of exchange can be discounted at a discount house (interest deducted from the face value) and balance can be collected immediately.

7. Documentary Credit.
  • CIMA defines it as,
"A document issued by the bank on behalf of the customer authorising the person to draw money to a specified amount from its branches or correspondents, usually in another country, when the condition set out in the document have been met."

8. Forfeiting.
  • This is situation where exporter of a high value Goods has been identified foreign customer.
  • The customer is willing to buy the good but is unable to buy immediately.
  • Exporter is unable to sell immediately.
  • Then the bank in the exporters company will become the forfeiting company.
  • They will make the payments and collect the amount in instalments from the foreign customer.

Debt Yields.

The rate of return. or yield on, debentures, loan stocks and bonds is measured in two different ways,

1. Interest Yield.( running yield, flat yield)

Interest Yield =  Gross Interest     x 100
               Market Value


2. Yield To Maturity.(redemption yield)
  • Percentage return provided by the investment.
  • If the instrument is irredeemable,
Yield =  Return (Interest)     x 100
  Market Value

  • If the instrument is redeemable – IRR
  • Coupon Rate – The rate of interest at the time of issuing the instrument.

Short Term Investments

1. Treasury Bill
  • The govt. will borrow from the investors for duration less than 365 days.
  • There is no credit risk (Risk of default) as the government is borrowing.
  • There is no interest payment during the time period of the treasury bill, but the investor will pay the discounted value at time of purchasing the maturity, where the face value will be paid at maturity.
  • Example – A 100,000 face value treasury bill with a duration of 365 days can be obtained at 87,000 if the interest rate prevailing is 15%. However, if the interest rate increases the value of the treasury bill will decline. If the interest rate increased to 17%, the value of the treasury bill today will be 85,500.

2. Bank Deposit
  • The organisation can deposit the short term surplus in a bank account to obtain interest.

3. Certificate of Deposits.
  • This is where money will be deposited and the bank will issue a certificate indicating the amount deposited and the rate of interest applicable.
  • It is issued in bearer form (not issued in the name of a person). Whoever who holds the document will become the owner.

4. Money Market Accounts.
  • This is where organisations can deposit money in a special account.
  • The money deposited will be provided to the money markets where the banks will borrow from one another.
  • The interest paid will depend on interbank borrowing rate.

5. Local Authority deposits.
  • Money will be deposited with a local authority to receive a specified rate of interest.

6. Commercial Paper.
  • This is where organisations can directly borrow from customers, where the duration is less than one year.
  • Assets will not be provided as security, but it can be discounted at any given time, therefore it is a negotiable instrument.

7. Local Authority Bonds.
  • This is where an organisation can invest in an instrument which has a lifetime of more than one year and it is issued by the local authority.
  • It can be discounted at any given time.

8. Corporate Bonds.
  • These are instruments having a life of more than one year issued by organisations. It can be discounted at any given point of time.

9. Government Bonds.
  • Instruments issued by government, which has a life duration of more than one year. It can be discounted at any given point of time.





Managing Working Capital – Cash Flow.
Managing Working Capital – Cash Flow.
  • Knowledge
  • Example
  • Activity
Managing Working Capital – Receivables, Payables & Inventory.

Working Capital Management

The capital available to conduct the day to day operations of an org. normally the excess of current assets of current liabilities

Investment Decision
  • This is the decision involved with regard to accepting an investment, where any of the investment appraisal techniques would be used to identify the viability.
  • Commonly used is NPV.
  • If the project provides a positive NPV, then the project will be accepted and capital will be invested.
  • This is based on the shareholder wealth maximization.
  • Cash flows arising over a time period will be converted to today's value using a discount factor.
  • The discount factor will be the cost of capital of the company.

Financing Decision
  • If a project with a positive NPV is identified, then it should be determined how to finance the investment.
  • This decided whether the org. should raise finance through equity, debt or a mix of debt & equity.
  • Org. financing method will determine the cost of capital.

Conservative
  • The management is willing to take a lower risk.
  • Total NCAs, total permanent CAs & part of fluctuating CAs will be financed using long term sources of finance.
  • Only part of fluctuating CAs will be financed using short term finance.

Aggressive
  • Willing to accept a higher risk.
  • Total NCAs & part of permanent CAs will be financed based long term sources.
  • Total fluctuating CAs & part of permanent CAs will be short term financed.

Moderate
  • The mgmt will be between conservative & aggressive.
  • The total NCAs & Total Permanent CAs will be long term financed & total fluctuating CAs will be short term financed.

Liquidity Ratios
  • This identifies the readily available cash to meet the obligations when requires.
  • This will help indicate the availability of assets to meet the liabilities.
Current Ratio.                                      Quick Asset Ratio.
CAs                                                     CAs – Inventory
CLs                                                            CLS           

Efficiency Ratios
  • This provides an idea with regard to the position of the company's mgmt of working capital.
Inventory Turnover Days.                                      Receivables Turnover Days.
 Inventory x 365                                                    Trade Receivables x 365
Cost of Sales                                                                    Sales                     
Payables Turnover.     
 Trade Payables x 365        
Purchases              


Working Capital Cycle

RM days + WIP days + FGs days + Trade Rec. days –Trade Pay. Days

  • This will indicate the average time period over which the money is tied up in WC.

Note
  • RM days & WIP days is for manufacturing orgs.
  • RM days uses RM purchases.
  • WIP days uses Cost of Goods manufactured or Cost of Sales.
  • FG days uses Cost of Sales.

Shortening the WC Cycle
  • Orgs. Should try to reduce the WC cycle for which the orgs. Should consider,
    • Reducing RM stocks.
    • Reducing WIP.
    • Reducing FGs.
    • Reducing Trade Receivables.
    • Increase Trade Payables without adversely affecting the orgs.
    • Reduce credit given to customers
    • Debt factoring.

Overtrading
  • This is a situation where a company is trading above the limit possible for the company considering the availability of resources.
  • The company agrees or commits to such trading ignoring the availability of short term resources.

Symptoms of Overtrading
  • Rapid increase in revenue.
  • Increase in receivables.
  • Increase in payable period.
  • Fall in liquidity ratios.
  • Decrease in cash balances.
  • Decrease in profit margins.

Remedies for Overtrading
  • Use equity finance rather than debt financing.
  • Maintain a credit control policy.
  • Manage the inventory levels.

Managing Receivables
  • Orgs. Can increase sales & profits by selling on credit. but the following cost will be incurred,
    • Cost of bad debts.
    • Cost of debt collection.
    • Cost of capital tied up in units sold on credit..
    • Cost of factoring.
    • Cost of discounts.
  • Cash Discounts can be used as a method of reducing the receivable days and improve cash flows.
    • This will speed up the collection but reduce the sales.
    • Reduce bad debts, cost of collecting debts
    • Improve cash flow.

Credit Cycle
  • This identifies the cycle of receipt of customers order & receipt of cash payment from the customer.
  • Longer the credit cycle, the longer will the cash be tied up in WC, hence it important to reduce the length of the credit cycle

Credit Control
  • There should be limits on credit sales, where the terms of trade should be agreed
    • If the credit customers are not settling on the due dates, then the orgs can consider charging interest for the delay.
    • Reducing the credit sales to customers who delay payments.
    • Use debt recovery services, consider factoring or obtain bills of exchange.

Assessing credit worthiness of customers
  1. Past records.
  2. Credit rating provided by the company.
  3. Liquidity position of the company through the financial statements.
  4. Bank statements.
  5. Financial statements.
  6. Website of the customer.

Payment terms
  • An agreement should be available. Where the terms should include the specified price, the date of delivery, payment date & the discounts offered.
  • Payments can be within a specified period, specific period with discounts, weekly credit or based on the delivery date.
  • Payment can be through cash, cheques, banker's draft, direct debit, credit cards or debit cards.
  • It is important to have a well trained, dedicated, well defined procedure of collecting debts & personnel, where monitoring of customers should be done on a regular basis. This will help reduce the debt outstanding & reduce the probability of default.

Note
  • An age analysis can be carried out, where it will identify the list of customers who owe money, showing the period of time & total amount owed.

Credit Insurance
  • This is a situation where the orgs. Sells on credit can obtain an insurance cover where the insurance company will pay if
  1. Customer defaults payment.
  2. Customer delays the payment.

Trade Payables
  • This indicates the money that the company owes to the suppliers for the Goods & Services.
  • It's a normal part of the business & can be viewed as a free source of finance.
  • At a time of payment an entity can use the benefit of discounts.
  • An age analysis of trade payables may be produced in order to identify the suppliers we would owe money.

Inventory
  • Orgs. Would invest large amounts of capital on Inventory, hence by better managing it the orgs. Could manage the cost.
  • RMs – used in the manufacturing or production process.
  • WIPs – party completed goods.
  • FGs – completed goods which are ready for sale.

Costs of Inventory
  • Cost of Holding (CH) – all costs relating to the maintaining of inventory.
  • Cost of Ordering (CO) – all costs relating to ordering.
  • Stock Out Cost &ndah; this is the cost of being without inventory.
  • Unit cost is the cost of acquiring one unit.

Inventory Control Policy

Maintaining a proper inventory control system is of utmost importance, where it should focus on maintaining a minimum cost, providing satisfactory service levels to customers, ensuring the smooth running of the company & maintaining flexibility.


Inventory Control Systems

Reorder Level System.(ROL)
  • This is the level stock at which an order should be placed to purchase inventory.
  • Minimum stock level would be maintained in order to avoid the variation in the demand & lead time.

Maximum Usage x Maximum Lead Time


Period Review System

This will monitor the stocks on a periodic basis or based on a fixed interval.

Economic Order Quantity.(EOQ)
  • This is the number units to be ordered at a time, so that the total cost relating to inventory will be at its lowest.
  • It can be calculated using the following formula,
EOQ = √( 2 x D x CO / (CH)

D – Annual Demand.
CO – Cost of ordering Per Order.
CH – Cost of Holding Per Unit Per Annum.

Quantity Discounts
  • This is common thing among suppliers, where they would offer discounts on large quantities purchased. This will help reduce the unit cost as well as order cost.

Lead Time
  • The time difference between issuing the orders & their receipt.



Managing Working Capital – Receivables, Payables & Inventory.
Managing Working Capital – Receivables, Payables & Inventory.
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Question 1

The following data relate to a manufacturing company. At the beginning of April there was no inventory. During the month 4,000 units of product A were produced, but only 3,450 units were sold. The financial data for product A for April were as follows:
£
Materials 75,000
Labour 54,600
Variable production overheads 17,800
Fixed production overheads 32,000
Variable selling costs 24,000
Fixed selling costs 30,750
Total costs for A for April 234,150

The value of inventory of A at 30th April using a marginal costing approach is

  1. £ 24,667.50
  2. £ 17,820.00
  3. £ 20,267.50
  4. £ 23,567.50

The value of inventory of A at 30th April using a throughput accounting approach is

  1. £ 17,820.00
  2. £ 10,312.50
  3. £ 20,267.50
  4. £ 12,760.00

Question 2

The fixed overhead volume variance is defined as
  1. The difference between the budgeted value of the fixed overheads and the standard fixed overheads absorbed by actual production.
  2. The difference between the standard fixed overhead cost specified for the production achieved, and the actual fixed overhead cost incurred.
  3. The difference between budgeted and actual fixed overhead expenditure.
  4. The difference between the standard fixed overhead cost specified in the original budget and the same volume of fixed overheads, but at the actual prices incurred.

Question 3

A company has budgeted break-even sales revenue of £700,000 and fixed costs of £280,000 for the next period.

The sales revenue needed to achieve a profit of L75,000 in the period would be

  1. £ 775,000
  2. £ 1,937,500
  3. £ 887,500
  4. £ 1,200,000

Question 4

A textile company had estimated the staff requirements for a particular job as follows:

40 hours of skilled operator at £150 per hour $6000
60 hours of semi skilled operator at $80 per hour $4800
Total employee cost for the job $10,800

The actual information for the job is recorded below

50 hours of skilled operator at $150 per hour $7500
50 hours of semi skilled operator at $80 per hour $4000
Total employee cost for the job $11,500

A semi skilled operator stated that for 5 hours of the 50 hours recorded, he had no work to do.

A) Labour mix variance
B) Labour efficiency variance
C) Idle time variance

Labour mix variance - $ 1080 (adverse)

Actual Hours Standard Mix Mix Variance Hours Rate per hour $
Skilled 50 40% 38 12 Adv $ 150 $ 1800
Semi 45 60% 5 9 Fav $ 80 $ 720
95 $ 1080

Labour Efficiency variance

Actual Hours at Standard rate
Skilled (50hrs * $150) = $7500
Semi skilled (45 * $80) = $3600
$11100

Variance (10800 – 11100) = $ 300 adverse

Idle time hours are excluded in the calculation of labour mix and efficiency variances.

Idle time 5 hours * $80 = $400 adverse

Question 5

A company has a standard costing system in place. Information from the budget for May is shown below

Sales 1800 units
Production 2500 units
Direct costs $10 per unit
Variable overhead $6per unit

The budgeted fixed production overhead costs for May were $15,000

The budgeted profit using marginal costing for April was $7,500

i. Calculate the budgeted profit for April using absorption costing

ii. Briefly explain two situations where marginal costing is more useful to management than absorption costing.

The OAR 15000/2500 = 6

Inventory is budgeted to increase and therefore absorption costing profit will be higher than marginal costing profit.

Absorption costing profit = 7500 + [(2500-1800) * 6] = $11,700.

Marginal Costing sheds more focus on contribution, which changes with the sales levels proportionally, thus making decision making and planning activities easier. In addition, sensitivity and “what if” analysis and reports can be generated more conveniently when marginal costing is used.

Question 6

X plc is a garment manufacturing company that supplies clothing items to retail stores. The performance and profitability of the company over the years have been satisfactory but the management is concerned about the profitability of all individual orders. They are looking at the option of implementing a new budgeting system that incorporates Activity Based Costing to ensure all orders are profitable.

Customers are charged in the following manner:

List Price of the Garments ordered + charge for selling and distribution overheads + a profit margin

At present, X Plc uses a simple absorption rate that considers the budgeted annual selling and distribution costs and the budgeted annual total list price of the orders.

It has been discovered that many customers place frequent orders of smaller values. Therefore the natures of selling and distribution costs were investigated. Following information was extracted from the budget for the next year.

List price of total garments supplied $15m
Number of customer orders 10,000
Selling and distribution costs $ Cost Driver
Packing 200,000 Size of package
Delivery 250,000 No.of deliveries
Invoice processing 300,000 Invoice lines
Other Overheads 170,000 No.of orders
1,120,000
  • Each order will be shipped in one package and will result in one delivery to the customer and one invoice. One customer order will never result in more than one delivery
  • Each invoice has a different line for each garment ordered. There are 35,000 invoice lines every year.
  • Delivery vehicles travel at full capacity and can carry 18 small packages or 6 large packages or any combination of large and small packages. Total delivery mileage specific to customers is budgeted to be 400,000 miles per year. $70,000 of delivery costs corresponds to the loading packages to the vehicles and the remaining cost is specific to delivery distance to customers.

The senior managers have ordered for the following two orders to be accounted for using the budgeted data, using the current approach and the proposed Activity Based Costing approach.

Order A Order B
Packaging size Large Small
Lines on invoice 10 6
Delivery distance 30 miles 20 miles
List price of garments $2000 $1100

a) With clear working, account for the selling and distribution overhead for each order A and B, using the current system and ABC method.

b) Prepare a report stating the

  • Each order will be shipped in one package and Strengths and the weaknesses of the ABC approach for X Plc
  • Possible action plan that X plc might consider with the information generated by the ABC system.

Current method

$1,120,000/$15m = 7.47% of list price of garments supplied

Order A: $2000 * 7.47% = $149.4

Order B: $ 1100 * 7.47% = $82.17

Proposed ABC system

Cost driver rates

Charge per invoice line = $300,000 / 35,000 = $8.57 per line

Charge per delivery trip (loading) = $70,000 / 1,500 = $47 per trip

Therefore for large package = $47 / 6 = $7.83

For small package = $47 / 18 = $2.61

Charge per delivery mile = $180,000 / 400,000 = $0•45 per mile

Other overheads allocated by orders = $170,000 / 10,000 = $17 per order

Order A Order B
Packaging $40 $25
Delivery (loading) $7.83 $2.61
(Miles) $13.50 $9
Invoice Processing $85.70 $51.42
Other Overheads $17 $17
Total charge for overheads $105.03 $164.03

Report to the Management of F plc on the Implications of Implementing an Activity-Based Costing Approach.

From Candidate

Date May

This report covers two issues: (i) an assessment of the strengths and weaknesses of the proposed activity-based costing approach, and (ii) recommendations for action the management of X plc might take.

i) Every accounting and budgeting system has its own strengths and weaknesses that are specific to the organization. For X plc, the following is applicable.

Strengths:

i. Allows the cost structures to be better understood and thus making decision making more accurate.

ii. Prices can be set at a more realistic level, corresponding to the exact resources utilized. This ensures that loss making orders are not accepted.

iii. Drives attention to those cost elements that are of higher values, so that necessary action can be taken to reduce them

iv. Prices are clearly justified, leaving no opportunity for any challenges by customers.

v. Decisions to outsource can be evaluated better.

Weaknesses:

i. The significant costs could be higher than the benefits.

ii. Data relating to activity level may still not be sufficiently detailed.

iii. There are elements in the ABC system that still may not be specific enough, particularly other overhead costs which means high concern should be given to the information.


ii.)The following recommendations could be made to the directors of F plc.

The current system is a simple, cost based method. However, a policy as this may not be the most suited and is only suitable at times where all total production is sold out. Thus, assuming that price is not closely linked to demand, a pricing policy that does no more than simply recover overheads and produce a profit may be deemed satisfactory. In this case, although the current charge for overheads is simple and cheap to calculate, it does not reflect the actual costs incurred by each order.

The new activity-based costing (ABC) system produces a measure of cost that better reflects the resources that have been used. This new ABC system produces very different costs to the previous system. However, the new costing system used, although a very simple version of ABC, is probably too complex for a pricing system.

As the first step in a review it would be instructive to check whether some orders are actually losing money. The activity-based cost analysis indicates that orders with many different products and those delivered over a long distance are expensive, in comparison with orders for a larger volume of few products with shorter delivery distances.

X will need to develop a pricing structure that would enable some of the key cost drivers to be reflected in the prices charged, and to let customers know the charge in advance.

Another possible strategy would be to stop accepting long distance orders by imposing a distance limit. It might be possible to out-source long distance deliveries, possibly along with a high charge for the long distance band in the charging table, as mentioned above. The costs based on the number of items on the invoice become very high when multiple products are ordered. This needs careful review. Would better systems using newer technology reduce these invoice costs – this is highly likely.

Question 1

The CIMA definition of zero-based budgeting is set out below, with two blank sections. "Zero-based budgeting: A method of budgeting which requires each cost element ___________, as though the activities to which the budget relates _______________." Which combination of two phrases correctly completes the definition?
    Blank 1 Blank 2
    		2. to be specifically justified could be out-sourced to an external supplier
    		3. to be set at zero could be out-sourced to an external supplier
    		4. to be specifically justified were being undertaken for the first time
    		5. to be set at zero were being undertaken for the first time

Question 2

The following extract is taken from the production cost budget of D plc:

Output 5000 units 6750 units

Total cost £22,000 £27,200

The budget cost allowance for an output of 7,000 units would be:

  1. £24,000
  2. £28,207
  3. £20,400
  4. £27,940

Question 1

A company uses standard absorption costing. The following information was recorded by the company for March:

Budget Actual
Output and sales (units) 4500 4900
Selling price per unit £29 £36
Variable cost per unit £10 £10
Total fixed overheads £36000 £37500

The sales price variance for March was

  • £31,500 favourable
  • £34,300 favourable
  • £31,500 adverse
  • £34,300 adverse

The fixed overhead volume variance was

  • £3,200 favourable
  • £3,200 adverse
  • £3,062 favourable
  • £3,062 adverse

Wrong Answer

The correct Answer is B

£29 - £36 = 7

£7 * 4900 = £ 34,300 favourable

Wrong Answer

The correct Answer is A

36,000/4500 = 8

£8 * (4900-4500) = £3200 favourable

Correct Answer

Question 2

An unquoted bond has a coupon rate of 6% per annum and will repay its face value of $100 on its maturity in 4 years’ time. The yield to maturity on similar bonds is estimated to be 4% per annum. The annual interest has just been paid for the current year. Calculate the current expected market value of the bond.

Years Cashflow DCF PV
1-4 Interest 6 3.630 21.78
4 Redemption 100 0.855 85.50
107.28

Answer $107.28

The bond will generate annual interest of 6% on the face value which is $100 for 4 years. In addition at the end of four years the redemption value of $100 will be paid back. When discounted with the suitable rate of 4%, the figures depict that the bond will be sold currently for a value of $107.28.

Question 3

B Ltd uses a standard labour hour rate to charge its overheads to its clients’ work. During the last annual reporting period production overheads were under-absorbed by L19,250. The standard labour hours for the period was expected to be 38,000 hours while the standard hours actually charged to clients were 38,500. Actual Production Overheads of L481,250 was incurred during the period. The budgeted production overheads for the period were

  • £456,000
  • £462,000
  • £475,000
  • None of the above.

Correct Answer

Wrong Answer

The Correct Answer is A

Under absorbed 19,250
Actual 481,250
Charged to clients 462,000
Overhead rate £462,000/38,500 = £12 per hour
Budgeted overheads = 38,000 x £12 = £456,000

Question 4

A flexible budget is

  • A budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes.
  • A budget for a twelve month period which includes planned revenues, expenses, assets and liabilities.
  • A budget which is prepared for a rolling period which is reviewed monthly, and updated accordingly.
  • A budget for semi-variable overhead costs only

Correct Answer

Wrong Answer

The correct answer is A.

These budgets are specially produced to take into account uncertainties in the business environment.

Question 5

The following information has been calculated for a business:

Trade receivables collection period 76 days
Trade payables payment period 45 days

If the working capital cycle is 139 days, the inventory turnover period is

  • £456,000
  • £462,000
  • £475,000
  • None of the above.

Correct Answer

Wrong Answer

The Correct Answer is D

139 + 45 -76 = 108 days

Working capital cycle = receivables collection period + inventory turnover period – payables payment period

Question 6

A $1,000 bond has a coupon rate of 8% and will repay its nominal value when it matures in four years' time. The bond will be purchased today for $900 ex interest and held until maturity.

Calculate, to the nearest 0.01%, the yield to maturity for the bond based on today's purchase price.

Interest is 80/900 i.e. 8.9% plus capital gain at maturity of $100 therefore discount initially at 10%.

Cash flows DCF @ 10% PV DCF @ 12% PV
$ $ $
Year 0 (900) 1.000 (900.00) 1.000 (900.00)
Year 1-3 80 2.487 198.96 2.402 192.16
Year 4 1,080 0.683 737.64 0.636 686.88
NPV 36.60 -20.96

By interpolation:

10% + (2% (36.6/ (36.6 + 20.96)) = 11.27%

Question 7

Explain how a budget can cause conflict between “motivation” and “control”.

Budget preparation is an important exercise for the whole company. Thus it is important that when preparing budgets, realistic figures and estimates are used because budgets fulfil important planning aspects in relation to liquidity, resources and production. For effective control purposes, budgets must be very close to actual performance.

On the contrary, for purposes of motivation, the targets set should be challenging. Therefore a battle of realistic and challenging targets arises. However, no aspect is less significant. Organization should ensure that they are clear on, as to what aspect they give priority over the other and make an effort to incorporate both the aspects into budgets.

Question 8

JK has outstanding balance of trade receivables of $95,000 after allowing for the bad debts. JK’s estimate for sales for the coming year is $500,000. All sales are on credit.

JK is able to anticipate, based on experience that bad debt will amount to 5 % of sales in the next year. Receivable days at the end of the period are 68 days.

  1. Calculate the expected receipts from customers during the next year.
  2. Describe two methods how JK can reduce the possibility of bad debts occurrence.
  • Trade receivable at end of the year = $500,000 / 365 x 68 = $93,150

    • Bad debts = ($500,000 – $93,150) x 5% = $20,342.50

  • To minimize the occurrence of bad debts, JK can adopt the following methods.

    • Cash collected = $95,000 + $500,000 - $93,150 - $20,342.50 = $481,507.50

  • Ensure that all new customers have a full credit rating check before the granting of credit. This can be achieved by the use of credit rating organisations or by the taking of references from the prospective customer.
  • Carry out routine credit ratings checks on existing customers, in particular the slow payers.
  • Ensure that debt collection procedures are efficient in chasing up late payers.
  • Charge penalties for late payment or offer discounts to encourage customers to pay early.
  • Ensure that credit limits are allocated to customers and enforced by the credit control department. No sales should be allowed if credit limits have been exceeded, effectively putting the account on “stop” should this happen.

Question 1

A master budget comprises of the,

  • budgeted income statement and budgeted cash flow only.
  • budgeted income statement and budgeted balance sheet only.
  • budgeted income statement and budgeted capital expenditure only.
  • budgeted income statement, budgeted balance sheet and budgeted cash flow only.

Wrong Answer

The Correct Answer is D

The master budget contains budgets of all of the three financial statements.

Correct

Question 2

A company uses standard absorption costing. The following information was recorded by the company for March:

Budget Actual
Output and sales (units) 4500 4900
Selling price per unit £29 £36
Variable cost per unit £10 £10
Total fixed overheads £36000 £37500

The sales price variance for March was

  • £31,500 favourable
  • £34,300 favourable
  • £31,500 adverse
  • £34,300 adverse

The fixed overhead volume variance was

  • £3,200 favourable
  • £3,200 adverse
  • £3,062 favourable
  • £3,062 adverse

Wrong Answer

The correct Answer is B

£29 - £36 = 7

£7 * 4900 = £ 34,300 favourable

Wrong Answer

The correct Answer is A

36,000/4500 = 8

£8 * (4900-4500) = £3200 favourable

Correct Answer

Question 1

Overheads will always be over-absorbed when

  • Actual output is higher than budgeted output.
  • Actual overheads incurred are higher than the amount absorbed.
  • Actual overheads incurred are lower than the amount absorbed.
  • Budgeted overheads are lower than the overheads absorbed.

Wrong Answer

The Correct Answer is C

The overheads will be absorbed based on a predetermined rate therefore differences may arise.

Correct

Question 2

Which of the following statements apply to feed forward control?

  1. It is the measurement of differences between planned outputs and actual outputs.
  2. It is the measurement of differences between planned outputs and forecast outputs.
  3. Target costing is an example.
  4. Variance analysis is an example.
  • (i) and (iii)
  • (i) and (iv)
  • (ii) and (iii)
  • (ii) and (iv)

Wrong Answer

The Correct Answer is C

It is a control mechanism used to measure deviations arising from changing variables in the external environment.

Correct

Question 3

A documentary credit is

  • A negotiable instrument, drawn by one party on another, who by signing the document acknowledges the debt, which may be payable immediately or at some future date.
  • A document issued by a bank on behalf of a customer authorising a person to draw money to a specified amount from its branches or correspondents, usually in another country, when the conditions set out in the document have been met.
  • A series of promissory notes, guaranteed by a highly rated international bank, and purchased at a discount to face value by an exporter’s bank.
  • A form of export finance where the debt is sold to a factor, at a discount, in return for prompt cash.

Wrong Answer

The Correct Answer is B

Documentary credit, also known as letters of credit, is an important source of short term finance specially for exporters.

Correct

  • Syllabus Area
    • Basic Aspects of Management Accounting
    • Cost Accounting Systems
    • The Theory and Practice of Standard Costing
    • Standard Costing & Performance Evaluation
    • Developments in Management Accounting
    • Section Summary
    • Mini Test
    • The Nature & Purpose of a Budget
    • Budgetary Preparation
    • Forecasting & Planning
    • Programme Planning Budgeting System. (PPBS)
    • Budgetary Control
    • Section Summary
    • Mini Test
    • Capital Budgeting & Project Appraisal
    • Advanced Investment Appraisal
    • Section Summary
    • Mini Tests
    • Investment Appraisal with Risk & Uncertainty
    • Section Summary
    • Mini Tests
    • Managing Working Capital - Cash Flow
    • Managing Working Capital - Receivables, Payables & Inventory
    • Section Summary
    • Mini Tests











  • Tests

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