Chapter Chapter Chapter Chapter 1: 1: 1: 1: Costing Costing Costing Costing Definition Definition Definition Definition This is a technique and processes of ascertaining costs, the classifying, recording and appropriate allocation of expenditure for the determination of the costs of products or services, the relation of these costs with sales values and the ascertainment of profitability. Overheads Overheads Overheads Overheads • Allocation Allocation Allocation Allocation This is the term used, where overhead cost items are charged to a specific cost centre, without the need for any estimating procedure. • Apportionment Apportionment Apportionment Apportionment This occurs when the total value of an overhead item is shared between two or more cost centre. The apportionment basis used must reflect the benefit extracted by a cost centre. • Re-apportionment Re-apportionment Re-apportionment Re-apportionment Re-apportionment occurs when service cost centre overheads are charged to user cost centre. This will always be in proportion to the extend of service provided. • Absorption Absorption Absorption Absorption This is the item used when overhead costs are charged into cost units from the production cost centre. A number of different bases are available. A business incurs costs and creates a cost unit. All costs incurred must be charged to the cost unit produced in order to determine the cost per cost unit. There are 2 types of costs, namely:- (a) Direct costs - A cost incurred by the cost unit only and incur in such proportions that the amount can be determined by some form of physical measurement of the cost unit. (b) Indirect costs - A cost which is although incurred for the cost unit, cannot be economically charged to the cost unit. In order to charge overheads to cost unit, a series of distributions will be used such as:- (a) Primary distribution – Allocation and / or apportionment of overheads to cost centre. (b) Secondary distribution – Reapportionment of overheads from SCC (Service Cost Centre) to PCC (Production Cost Centre) (c) Final distribution – Absorption of overheads from PCC (Production Cost Centre) into the cost units. In the first distribution, overheads will be allocated and apportioned to cost centres. Allocation and apportionment will be done or recorded in a document called the Overhead Analysis / Distribution Sheet.
This is a technique and processes of ascertaining costs, the classifying, recording and appropriateallocation of expenditure for the determination of the costs of products or services, the relation ofthese costs with sales values and the ascertainment of profitability.
OverheadsOverheadsOverheadsOverheads
•••• AllocationAllocationAllocationAllocationThis is the term used, where overhead cost items are charged to a specific cost centre,without the need for any estimating procedure.
•••• ApportionmentApportionmentApportionmentApportionmentThis occurs when the total value of an overhead item is shared between two or more costcentre. The apportionment basis used must reflect the benefit extracted by a cost centre.
•••• Re-apportionmentRe-apportionmentRe-apportionmentRe-apportionmentRe-apportionment occurs when service cost centre overheads are charged to user costcentre. This will always be in proportion to the extend of service provided.
•••• AbsorptionAbsorptionAbsorptionAbsorptionThis is the item used when overhead costs are charged into cost units from the productioncost centre. A number of different bases are available.
A business incurs costs and creates a cost unit. All costs incurred must be charged to the cost unitproduced in order to determine the cost per cost unit. There are 2 types of costs, namely:-
(a) Direct costs - A cost incurred by the cost unit only and incur in such proportions that the amountcan be determined by some form of physical measurement of the cost unit.
(b) Indirect costs - A cost which is although incurred for the cost unit, cannot be economicallycharged to the cost unit.
In order to charge overheads to cost unit, a series of distributions will be used such as:-
(a) Primary distribution – Allocation and / or apportionment of overheads to cost centre.
(b) Secondary distribution – Reapportionment of overheads from SCC (Service Cost Centre) toPCC (Production Cost Centre)
(c) Final distribution – Absorption of overheads from PCC (Production Cost Centre) into the costunits.
In the first distribution, overheads will be allocated and apportioned to cost centres. Allocation andapportionment will be done or recorded in a document called the Overhead Analysis / DistributionSheet.
There are two types of cost centre:-
1) Production Cost Centre (PCC) – A PCC is a CC which is directly involved with the creation of the cost unit.As such, overheads in PCC can be easily charged to the cost units.
2) Service Cost Centre – A SCC are not involved with the cost unit’s. They exist to provide services to other(users) cost centre.
As such, overheads allocated and / or apportioned to SCC cannot be charged to the cost units. Thus, overheadsin SCC must be reapportioned until all overheads are in the PCC.
In the primary distribution, overhead items will be allocated or apportioned to cost centre. However,allocation will be possible only if there is some form of direct link between the item and the cost centre.If a link cannot be clearly established, overhead items may be apportioned using an appropriate basis.
Bases which are commonly used include the following:-
1. Machine hour / Direct labor hour2. Area (Space)3. Number of employees4. Value of plant, machinery, stock5. Wages
A business may have more than one type of cost centre. A production cost centre is one which is directlyinvolved with the creation of the cost unit. A service cost centre, on the other hand, are not directly involved withthe cost unit but exists to provide services to other cost centres.
Overheads allocated or apportioned to service cost centres must be re-apportioned to production cost centres, asonly they are in contact with the cost units, thereby, enabling absorption to the cost units.
Reapportionment will always depend upon the extend of services provided.
Overheads from Service Cost Centres may be reapportioned to Product Cost Centres using one of four methodsbelow:-
Reapportionment is divided into 2 types, namely as follows:-
(a) Reapportionment with interservice
(b) Reapportionment without interservice
* InterserviceInterserviceInterserviceInterservice is also called Reciprocal Service. This refers to a situation where a SCC provides services toanother SCC and vice versa.
There are four (4) methods that can be adopted in order to compute the overheads after apportionment. Thesemethods are:-
Overhead is absorbed in the cost units produced in each cost centre. It is the charging of accumulated costs tocost units.
This is sometimes referred to as overheadoverheadoverheadoverhead recovery.recovery.recovery.recovery.
Absorption of overhead costs is required for:-
(a) valuation of work-in-progress(b) valuation of finished goods(c) profit measurement(d) decision making
In order to absorb overheads into cost units, an absorption base will be used. For each basis a predeterminedabsorption rate will be calculated, to be applied to the actual base.
The following are the three bases / groups at which overhead can be absorbed:-
(a) Hours based(b) Cost based(c) Production output based
The department overhead rates are calculated using different allocation bases such as:-
(i) Direct labor hours(ii) Machine hours(iii) Direct material cost(iv) Direct labor cost(v) Prime cost
The use of a predetermined absorption rate will give rise to over / under absorbed overhead since the actualoverhead is likely to be different from the estimate used to calculate the absorption rate.
Two reasons for this:-
• Actual activity differs from the activity contained in the budgeted data• Actual production overhead incurred differ from the estimate contained in the predetermined rate
Actual overhead > Overhead absorbed = Under absorbed
Actual overhead < Overhead absorbed = Over absorbed
Example 1
A company produces several products which pass through the two production departments in its factory. Thesetwo departments are concerned with filling and sealing operations. There are two departments, maintenance andcanteen, in the factory.
Predetermined overhead absorption rates, based on direct labor hours, are established for the two productiondepartments. The budgeted expenditure for these departments for the period just ended, including theapportionment of service department overheads, was £110040 for filling, and £53300 for sealing. Budgeted directlabor hours were 13100 for filling and 10250 for sealing.
Service department overheads are apportioned as follows:
Maintenance – Filling 70%
- Sealing 27%
- Canteen 3%
Canteen - Filling 60%
- Sealing 32%
- Maintenance 8%
During the period just ended, actual overhead costs and activity were as follows:
£ Direct labor hours
Filling 74260 12820
Sealing 38115 10075
Maintenance 25050
Canteen 24375
Required:Required:Required:Required:
Calculate the overheads absorbed in the period and the extend of the under / over absorption in each of theproduction departments.
Cost accumulation means the building up of the cost of something i.e. cost of the end product. For example, unitof production, job or services. There are two different costing principles which are used for this purpose namely:-
a) Marginal costing – “A principle whereby variable costs are charged to cost units and the fixed costattributable to the relevant period is written off in full against the contribution for that period”
b) Absorption costing – “A principle whereby fixed as well as variable costs are allotted to cost units, and totaloverheads are absorbed according to activity level”
Marginal costing is a costing approach which is based on the concept that only variablevariablevariablevariable productionproductionproductionproduction costscostscostscosts areareareareproductproductproductproduct costcostcostcost. It is sometimes called direct costing or period costing or variable costing.
Therefore, only variable costs (i.e. direct material, direct labor, variable production overhead, variable cost ofadministration and sales) are charged to cost units. Fixed costs are not absorbed into cost of production insteadare treated as period costs and are written off to the profit and loss account (contribution earned) at the periodwhen it is incurred.
Marginal costing system values stock and WIP at variable production cost, i.e. direct plus variable productionoverheads.
*Contribution may be calculated on a unit basis or in total
ContributionContributionContributionContribution provides useful information for decision making. If selling price and variable cost is constant,contribution is the same whatever the activity level.
Since fixed cost per unit decrease each time an additional unit is made so profit per unit rises with every increasein activity. Profit per unit changes each time the level of activity changes.
� No apportionments, which are frequently on an arbitrary basis of fixed costs to products or departments.
� Where sales are constant, but production fluctuates, marginal costing shows a constant net profitwhereas absorption costing shows variable amounts of profit.
� Under or over absorption of overheads is almost entirely avoided.
� Fixed overheads are incurred on a time basis. Therefore, it is logical to write them off in the period theyare incurred and this is done using marginal costing.
The main disadvantage of marginal costing are that closing inventory is not valued in accordance with SSAP 9principles and that fixed production overheads are not “shared” out between unit production, but written off in fullinstead.
Absorption costing approach is based on the concept that all variablevariablevariablevariable as well as fixedfixedfixedfixed productionproductionproductionproduction overheadsoverheadsoverheadsoverheadsare productproductproductproduct cost.cost.cost.cost. Thus, the valuation of stock and work-in-progress contain both variable and fixed costs. It isalso known as full costing or conventional costing. Fixed production overheads are absorbed into the unitsthrough the use of a predetermined absorption rate.
In other words, absorption costing is a method of product costing which aims to include in the total cost of aproduct (unit, job, process and so on) an appropriate share of the organization’s total overhead. An appropriateshare is generally taken to mean an amount which reflects the amount of time and effort that has gone intoproducing a unit or completing a job.
SSAP 9 requires the use of normal level of activity in the calculation of overhead absorption rate. Normal level ofactivity would mean the expected or budgeted volume of activity (i.e. budgeted units or hours). In absorptioncosting it is not necessary to distinguish variable and fixed cost in the profit statement.
AdvantagesAdvantagesAdvantagesAdvantages
� Value stocks according to the financial accounting principle contained in SSAP 9.� The matching concept requires that all production costs (including fixed production overheads) be
matched against revenue.� It is taking prudence too far to exclude fixed production overheads as they will be recovered in the
selling price.� Fixed costs are a substantial and increasing proportion of costs in modern industries. Production cannot
be achieved without incurring fixed costs which thus form an inescapable part of the cost of production.They should therefore be included in stock valuation.
� Analyzing under / over absorption of overhead is a useful exercise in controlling costs of anorganization.
� Where stock building is a necessary part of operations (seasonal products) the inclusion of fixed costsin stock valuation is necessary and desirable.
� It is not effective in helping management control costs.� The managers responsible for pricing decisions will not be able to see if a particular price will cover the
products directly attributable cost and produce a contribution towards other production costs and thegeneral overheads.
� It is not effective in the provision of useful information for decision making.
A manufacturing company has three production departments (A, B and C) and one service department in itsfactory. A predetermined overhead absorption rate is established for each of the production departments on thebasis of machine hours at normal capacity. The overheads of each production department comprise directlyallocated expenses and a share of the overheads of the service department, apportioned in the ratio 3:2:5 todepartments A, B and C respectively. All overheads are classified as fixed.
The following incomplete information is available concerning the apportionment and absorption of productionoverhead for a period:
Plant and machinery operating hours 1400 1400 700 700
Budgeted overhead costs for the next year are:
RM'000RM'000RM'000RM'000
Direct wage related costs 200
Supervisory salaries: bark removal 30
sawing 36
cleaning 14
canteen 12
Maintenance wages 40
Lighting and heating 54
Power 88
Production scheduling 26
Required:Required:Required:Required:
Calculate an appropriate overhead absorption rate for each production cost centre.
Q3Q3Q3Q3
Choyee Ltd intends to commence manufacturing a single product from 1 December. It is expected that thenormal level of production and sales will be 12000 units per month.
Budgeted costs per unit based on this level are:
£
Prime costs 10.50
Factory overheads 4.50
Factory cost 15.00
Selling / Administration overheads 5.00
Total cost 20.00
Add 25% profit 5.00
Selling price 25.00
One third of the factory overheads will vary with units produced, while the remainder is of a fixed nature. 80% ofthe selling / administration overheads will be treated as fixed period costs and the remainder will vary with unitssold. In the first month, the production is budgeted at 12800 units but sales are budgeted to be 11400 units.
Required:-Required:-Required:-Required:-
Produce 2 separate budgeted Profit & Loss Accounts for December, one based on the absorption principle andthe other based on the marginal principle.
Q4Q4Q4Q4
Fabric Ltd is a company producing textiles and has three production departments Fabrication, Designing andTailoring, and two service departments Sales and Advertising. Overheads have been attributed to thesedepartments as follows:
£
Fabrication 100000
Designing 75000
Tailoring 50000
Sales 25000
Advertising 10000
An analysis of services provided by each service department shows the following percentage of total time spentfor the benefit of each department.
Production Department Service Department
Fabrication Designing Tailoring Sales Advertising
Sales 30 30 20 -- 20
Advertising 50 10 30 10 --
Required:-Required:-Required:-Required:-
Apportion the service department costs to production departments using the following methods:
(a) Ignore interservice
(b) Elimination method
(c) Repeated distribution
(d) Simultaneous equation
Q5.Q5.Q5.Q5. A company is preparing its production overhead budgets and determining the apportionment of thoseoverheads to products. Cost centre expenses and related information have been budgeted as follows:-
Required:-Required:-Required:-Required:-(a) Using the direct apportionment to production departments method and bases of apportionment which you
consider most appropriate from the information provided, calculate overhead totals for the threeproduction departments.
(b) Using the information above and results as per (a), determine budgeted overhead absorption rates foreach of the production departments using appropriate bases of absorption.
(c) Assuming the total production overhead expenditure of the company in the question above was $176533and its actual activity was as follows:-
Machine Shop A Machine Shop B AssemblyDirect labour hours 8200 6500 21900Machine usage hours 7300 18700 -
Using the information above and in part (b), calculate the under- or over- absorption of overheads.
Q6.Q6.Q6.Q6.
Elsewhere Co has a budgeted production overhead of $180000 and a budgeted activity of 45000 machine hours.
Required:Calculate the under-/over-absorbed overhead, and note the reasons for the under-/over-absorption in thefollowing circumstances.
(a) Actual overheads cost $170000 and 45000 machine hours were worked.(b) Actual overheads cost $180000 and 40000 machine hours were worked.(c) Actual overheads cost $170000 and 40000 machine hours were worked.
A business forecastforecastforecastforecast is an estimate of the likely position of a business in the future, based on past orpresent conditions.
However, a budgetbudgetbudgetbudget is a statement of planned future results which are expected to follow from actionstaken by management to change the present circumstances.
Managers are responsible for planning and controlling a business for the benefit of its owners, andbudgets are essential tools for planning and controlling. Well-managed businesses have short-termbudgets for, say, the year ahead. Small businesses may function well enough with these, but largerbusinesses need to plan further ahead and prepare long-term budgets, in addition to the short-termones, for the next five, ten or even more years ahead. These plans are often known as rollingrollingrollingrollingbudgetsbudgetsbudgetsbudgets because, as each year passes, it is deleted from the budget and a budget for another year isadded. A budget for one year ahead will be detailed, but budgets for the following years may be lessprecise because of uncertainty about future trading conditions.
The manager of each department or function in a business is responsible for the performance of hisor her department or function. Separate operational, or functional, budgets must be prepared for eachdepartment or activity detailing the department’s revenue (if any) and expenses for a given period.The budgets will be prepared for sales, production, purchasing, personnel, administration, treasury(cash and banking), etc. opinions differ as to who should prepare these budgets.
Top-downTop-downTop-downTop-down budgetsbudgetsbudgetsbudgets are prepared by top management and handed down to departmental managers,who are responsible for putting them into effect. Such budgets usually have the merit of being wellcoordinated so that they all fit together as a logical and consistent plan for the whole business.However, departmental managers may not feel committed to keeping to these budgets as they havelittle or no say in their preparation and may be of the opinion that the budgets are unrealistic.
Bottom-upBottom-upBottom-upBottom-up budgetsbudgetsbudgetsbudgets are prepared by departmental managers and may be unsatisfactory because:
• They may not fit together with all the other departmental budgets to make a logical andconsistent overall plan for the business
• Managers tend to base their own budgets on easily achievable targets to avoid beingcriticized for failing to meet them; this will result in departments performing below theirmaximum level of efficiency and be bad for the business as a whole.
A budget committee, which should include an accountant, should coordinate the departmentalbudgets to ensure that they achieve top management’s plans for the business.
The benefits of budgets may be summarized as follows:-
1. They are formal statements in quantitative and financial terms of management plans.2. Their preparation ensures the coordination of all the activities of a business.3. When managers are involved in the preparation of their budgets, they are committed to
meeting them.4. Budgets are a form of responsibility accounting as they identify the managers who are
responsible for implementing the various aspects of the overall plan for the business.
ControlControlControlControl
Control involves measuring actual performance, comparing it with the budget and taking correctiveaction to bring actual performance into line with the budget. It is important that deviations from budgetare discovered early before serious situations arise. Annual departmental budgets are broken downinto four-weekly or monthly, or even weekly, periods, and departmental management accounts areprepared for those periods. These management accounts compare actual performance with budgetand must be prepared promptly after the end of each period if they are to be useful. If actual revenueand expenditure are better than budget, the differences (or variances) are described as favorablebecause they increase profit. On the other hand, if ‘actual’ is worse than budget, the variance isdescribed as adverse.
Departmental management accounts usually contain many items of revenue and expenditure with amixture of favorable and adverse variances. Managers should concentrate their attention on itemswith adverse variances and, to help managers focus their attention on these, management accountsmay report only the items with adverse variances. This is known as management by exception orexception reporting.
LimitingLimitingLimitingLimiting factors,factors,factors,factors, sometimes called principal budget factors, are circumstances which restrict theactivities of a business. Examples are:-
• Limited demand for a product• Shortage of materials, which limits production• Shortage of labor, which also limits production
Limiting factors must be identified in order to decide the order in which the departmental budgets areprepared. If the limiting factor is one of demand for the product, a sales budget is prepared first. Theother budgets will then be prepared to fit in with the sales budget. If the limiting factor is the availabilityof materials or labor, the production budget will be prepared first and the sales budget will then bebased on the production budget.
Sales budget are based on the budgeted volume of sales. The volume is then multiplied by the sellingprice per unit of production to produce the sales revenue.
Example
Xsel Ltd’s sales for the six months from January to June 2010 are budgeted in units as follows:-
January 1000; February 800; March 1100; April 1300; May 1500; June 1400.
The current price per unit is $15 but the company plans to increase the price by 5% on 1 May.
Manufacturing companies require production budgets to show the volume of production requiredmonthly to meet the demand for sales. It is important to check that production is allocated to thecorrect months.
Example
Xsel Ltd manufactures its goods one month before they are sold. Monthly production is 105% of thefollowing month’s sales to provide goods for stock and for free samples to be given away to promotesales. Budgeted sales for July 2010 are for 1800 units.
1. raw materials purchased by a manufacturer, or;2. goods purchased by a trader
A manufacturing company’s purchases budget is prepared from the production budget while a trader’spurchases budget is prepared from a sales budget. The purchases budget is calculated as follows:-
An expenditure budget includes payments for purchased materials (from the purchases budget) plusall other expenditure in the period covered by the budget. Ensure that:
• purchased materials are paid for in the correct month• all other expenses are included in the budget in accordance with the given information
Example
Xsel Ltd pays for its raw materials two months after the month of purchase. Its other expenses are asfollows:-
1. Monthly wages of $4000 are paid in the month in which they are due.
2. The staff are paid a commission of 5% on all monthly sales exceeding $15000. Thecommission is paid in the month following that in which it is earned.
3. General expenses are paid in the month in which they are incurred and are to be budgeted asfollows:January $6600; February $7100; March $6900; April $7000; May $7300; June $7500
4. Xsel Ltd pays interest of 8% on a loan of $20000 in four annual installments on 31 March, 30June, 30 September and 31 December.
5. A final dividend of $2000 for the year ended 31 December 2009 is payable in March 2010.
Required:-Required:-Required:-Required:-
Prepare an expenditure budget for Xsel Ltd for the six months ending 30 June 2010. All amountsshould be shown to the nearest $.
Cash budgets are prepared from the sales and expenses budgets. Special care must be taken withrespect to the following:-
• Sales revenue must be allocated to the correct months. Receipts from credit customers whoare allowed cash discounts must be shown at the amounts after deduction of the discounts.The discounts should not be shown separately as an expense.
• Payments to suppliers (purchases) must be shown in the correct months; read the questioncarefully.
Example
Xsel Ltd’s sales in November 2009 were $18000, and in December 2009 were $17600.
Of total sales, 40% are on a cash basis; 50% are to credit customers who pay within one month andreceive a cash discount of 2%. The remaining 10% of customers pay within two months.
$10000 was received from the sale of a fixed asset in March 2010. The balance at bank on 31December 2009 was $12400.
A master budget is a budgeted Profit and Loss Account and Balance Sheet prepared from sales,purchases, expense and cash budgets. The purpose of the master budget is to reveal to managementthe profit or loss to be expected if management’s plans for the business are implemented, and thestate of the business at the end of the budget period.
It is important to remember that the Profit and Loss Account must be prepared on an accruals basis,and the information in the functional budgets must be adjusted for accruals and prepayments; it isadvisable to identify these when preparing the cash budget. Much information additional to thatrequired for the functional budgets mentioned above will usually be given. Details of fixed assetswhich are to be sold or purchased will often be supplied; this information will usually be included in acapital budget.
Example
Meadowlands Ltd’s Balance Sheet at 31 December 2009 was as follows:
1. Goods are purchased one month before the month of sale.
2. Budgeted quarterly purchases and sales for the year ending 31 December 2010 are asfollows:
Purchases Sales
$ $
January – March 72000 132000
April – June 96000 156000
July – September 84000 168000
October – December 96000 144000
3. Meadowlands Ltd receives one month’s credit on all purchases and allows one month’s crediton all sales.
4. The following expenses will be incurred in the year ending 31 December 2010:a) rent of $1600 per quarter paid in advance on 1 January, 1 April, 1 July and 1 Octoberb) wages of $7200 payable each monthc) an insurance premium of $3000 for 15 months to 31 March 2011 paid on 1 January
2010d) other expenses of $20000 paid quarterly.
5. The company will purchase additional equipment costing $15000 on 1 April 2010.
6. A new motor vehicle will be purchased on 1 April 2010 for $12000.
7. A motor vehicle which cost $6000 and has a written down value of $3000 at 31 December2009 will be sold for $2000 on 1 July 2010.
8. The company depreciates equipment at 10% per annum on cost. It depreciates motorvehicles at 12.5% per annum on cost.
9. The company’s stock at 31 December 2010 will be valued at $32000.
The directors of Greenfields Ltd have prepared functional budgets for the four months ending 30 April2010. To discover the effect that the budgets will have on the company at the end of the four months,they require the accountant to prepare master budgets. The accountant is provided with the followingdata:
1. Sales and purchases for the four months from January to April 2010 are busgeted to be:-Sales Purchases
$ $
January 62500 25000
February 70000 20000
March 75000 30000
April 82500 37500
2. 40% of sales are to cash customers; one month’s credit is allowed on the remainder.
3. The company pays for its purchases in the month following purchase.
4. Selling and distribution expenses amount to 10% of sales and are paid in the month in whichthey are incurred.
5. Administration expenses amount to $20000 per month and are paid in the month in whichthey are incurred.
6. Stock at the 30 April 2010 is estimated to be valued at $22500.
7. Additional plant and machinery costing $60000 will be purchased on 1 March 2010.
8. Annual depreciation of fixed assets is based on cost as follows:
Freehold premises 3%; Plant and Machinery 20%. 50% of all depreciation is to be charged toselling and distribution expenses, and the balance to administration expenses.
9. Debenture interest is payable half-yearly on 30 June and 31 December.
10. A dividend of $0.10 per share will be paid on the ordinary shares on 30 April 2010.
11. $25000 will be transferred to the General Reserve on 30 April 2010.Required:-Required:-Required:-Required:-
IntroductionIntroductionIntroductionIntroductionBusinesses operate in an environment of uncertainty. Management rarely have precise forecasts regarding thefuture return to be earned from an investment. Usually, the best that can be done is to make an estimate of therange of the possible future inflows and outflows. There are two types of expectations individuals may haveabout the future: certainty and uncertainty.
CertaintyCertaintyCertaintyCertainty –––– Under expectations of certainty future outcomes can be expected to have only one value. That is,there is not a variety of possible future eventualities – only one will occur. Such situations are rare, but there aresome investments which are a reasonable approximation to certainty, for instance, lending to a reputablegovernment by purchasing three-month treasury bills. Unless you are very pessimistic and expect catastrophicchange over the next three months, such as revolution, war or major earthquake, then you can be certain ofreceiving your original capital plus interest. Thus a firm could undertake a project that had almost completecertainty by investing its funds in treasury bills, and receiving a return of, say, 5% per year. Shareholders maynot, however, be very pleased with such a low return.
RiskRiskRiskRisk andandandand uncertaintyuncertaintyuncertaintyuncertainty – The terms risk and uncertainty can be used interchangeably as risk refers to theoccurrence of an uncertain event. Strictly speaking, risk occurs when specific probabilities can be estimated forthe possible outcomes. Uncertainty applies in cases when it is not possible to assign probabilities (or evenidentify all the possible outcomes). Risk describes a situation where there is not just one possible outcome, butan array of potential returns. The range and distribution of these possible outcomes may be estimated on thebasis of either objective probabilities or subjective probabilities (or a combination of two).
ProbabilitiesProbabilitiesProbabilitiesProbabilitiesBecause decision problems exist in an uncertain environment, it is necessary to consider those uncontrollablefactors that are outside the decision maker’s control and that may occur for alternative courses of action. Theseuncontrollable factors are called events or states of nature. For example, in a product launch situation, possiblestates of nature could consist of events such as a similar product being launched by a competitor at a lower price,at the same price, at a higher price or no similar product being launched.
The likelihood that an event or state of nature will occur is known as its probability, and this is normallyexpressed in decimal form with a value between 0 and 1. A value of 0 denotes a nil likelihood of occurrencewhereas a value of 1 denotes absolute certainty – a definite occurrence. A probability of 0.4 means that the eventis expected to occur 4 times out of 10. The total of the probabilities for events that can possibly occur must sumto 1.0. For example, if a tutor indicates that a probability of a student passing an examination is 0.7 then thismeans that the student has 70% chance of passing the examination. Given that the pass/fail alternatives representan exhaustive listing of all possible outcomes of the event, the probability of not passing the examination is 0.3.
This information can be presented in a probability distribution. A probability distribution is a list of all possibleoutcomes for an event and the probability that each will occur. The probability distribution for the aboveillustration is as follows:
Outcome ProbabilityPass examination 0.7Do not pass examination 0.3
1.0Some probabilities are known as objective probabilities because they can be established mathematically orcompiled from historical data. Tossing a coin and throwing a die are examples of objective probabilities. Forexample, the probability of heads occurring when tossing a coin logically must be 0.5. This can be proved bytossing the coin many times and observing the results. Similarly, the probability of obtaining number 1 when adie is thrown is 0.166 (i.e. one-sixth). This again can be ascertained from logical reasoning or recording theresults obtained from repeated throws of the dice.
It is unlikely that objective probabilities can be established for business decisions, since many past observationsor repeated experiments for particular decisions are not possible; the probabilities will have to be estimatedbased on managerial judgement. Probabilities established in this way are known as subjective probabilitiesbecause no two individuals will necessarily assign the same probabilities to a particular outcome. Subjectiveprobabilities are based on an individual’s expert knowledge, past experience, and observations of current
variables which are likely to have an impact on future events. Such probabilities are unlikely to be estimatedcorrectly, but any estimate of a future uncertain event is bound to be subject to error.
The advantage of this approach is that it provides more meaningful information than stating the most likelyoutcome. Consider, for example, a situation where a tutor is asked to state whether student A and student B willpass an examination. The tutor may reply that both students are expected to pass the examination. This is thetutor’s estimate of the most likely outcome. However, the following probability distribution is preferable:
Outcome Student A Student BProbability probability
Pass examination 0.9 0.6Do not pass examination 0.1 0.4
1.0 1.0
Such probability distribution requires the tutor to specify the degree of confidence in his or her estimate of thelikely outcome of a future event. This information is clearly more meaningful than a mere estimate of the mostlikely outcome that both students are expected to pass the examination, because it indicates that it is mostunlikely that A will fail, whereas there is a possibility that B will fail. Let us now apply the principles ofprobability theory to business decision-making.
ProbabilityProbabilityProbabilityProbability distributionsdistributionsdistributionsdistributions andandandand expectedexpectedexpectedexpected valuevaluevaluevalueThe presentation of a probability distribution for each alternative course of action can provide useful additionalinformation to management, since the distribution indicates the degree of uncertainty that exists for eachalternative course of action. Probability distributions enable management to consider not only the possibleprofits (i.e. the pay-off) from each alternative course of action but also the amount of uncertainty that applies toeach alternative.
Example 1A manager is considering whether to make product A or product B, but only one can be produced. Theestimated sales demand for each product is uncertain. A detailed investigation of the possible sales demand foreach product gives the following probability distribution of the profits for each product.
Product A probability distribution OutcomeEstimated probability Weighted
Profits of $6000 0.1Profits of $7000 0.2Profits of $8000 0.4Profits of $9000 0.2Profits of $10 000 0.1
1.0
Product B probability distribution OutcomeEstimated probability Weighted
Profits of $4000 0.05Profits of $6000 0.1Profits of $8000 0.4Profits of $10 000 0.25Profits of $12 000 0.2
1.0
Which product should the company make?
ExpectedExpectedExpectedExpected valuesvaluesvaluesvaluesThe expected value (sometimes called as expected pay-off) is calculated by weighting each of the profit levels(i.e. possible outcomes) by its associated probability. The sum of these weighted amounts is called the expectedvalue of the probability distribution. In other words, the expected value is the weighted arithmetic mean of the
possible outcomes. The expected values of $8000 and $8900 calculated for products A and B take into accounta range of possible outcomes rather than using a single most likely estimate. For example, the single most likelyestimate is the profit level with the highest probability attached to it. For both products A and B in the aboveexample the single most likely estimate is $8000, which appears to indicate that we may be indifferent as towhich product should be made. However, the expected value calculation takes into account the possibility that arange of different profits are possible and weights these profits by the probability of their occurrence. Theweighted calculation indicates that product B is expected to produce the highest average profits in the future.
The expected value of a decision represents the long-run average outcome that is expected to occur if aparticular course of action is undertaken many times. For example, if the decision to make products A and B isrepeated on, say, 100 occasions in the future then product A will be expected to give an average profit of $8000whereas product B would be expected to give an average profit of $8900. The expected values are the averagesof the possible outcomes based on management estimates. There is no guarantee that the actual outcome willequal the expected value. Indeed, the expected value for product B does not appear in the probabilitydistribution.
MeasuringMeasuringMeasuringMeasuring thethethethe amountamountamountamount ofofofof uncertaintyuncertaintyuncertaintyuncertaintyIn addition to the expected values of the profits for the various alternatives, management is also interested in thedegree of uncertainty of the expected future profits. For example, let us assume that another alternative action,say, product C, is added to the alternatives in the example above and the probability distribution is as follows:
Product C probability distributionOutcome Estimated probability Weighted amountLoss of $4000 0.5Profit of $22000 0.5
Product C has a higher expected value than either product A or product B, but it is unlikely that managementwill prefer product C to product B, because of the greater variability of the possible outcomes. In other words,there is a greater degree of uncertainty attached to product C.
The conventional measure of the dispersion of a probability distribution is the standard deviation. The standarddeviation is the square root of the mean of the squared deviations from the expected value and is calculated fromthe following formula:
σ = n ∑ (A - ) P
where A are the profit-level observations, is the expected or mean value, P is the probability of each outcome,and the summation is over all possible observations, where n is the total number of possibilities.
Calculation of standard deviations for products A and B (based on the above example)
Product AProfit Deviation from StandardProbability Weighted($) expected value deviation amount
Product BProfit Deviation from StandardProbability Weighted($) expected value deviation amount
If we are comparing the standard deviations of two probability distributions with different expected values, wecannot make a direct comparison. Let’s consider the following probability distribution for another product, sayproduct D.
Product D probability distributionOutcome Estimated probability Weighted amount ($)Profits of $40000 0.05Profits of $60000 0.1Profits of $80000 0.4Profits of $100000 0.25Profits of $120000 0.2
1.0
The standard deviation for product D is $21424, but all of the possible outcomes are ten times as large as thecorresponding outcomes for product B. The outcomes for product D also have the same pattern of probabilitiesas product B, and we might conclude that the two projects are equally risky. Nevertheless, the standarddeviation for product D is ten times as large as that for product B. This scale effect can be removed by replacingthe standard deviation with a relative measure of dispersion. The relative amount of dispersion can be expressedby the coefficient of variation, which is simply the standard deviation divided by the expected value. Thecoefficient of variation for product B is 2142.40/8900 = 0.241 (or 24.1%), and for product D it is also 0.241(21424/89000), thus indicating that the relative amount of dispersion is the same for both products.
Measures such as expected values, standard deviations or coefficient of variations are used to summarize thecharacteristics of alternative courses of action, but they are poor substitutes for representing the probabilitydistributions, since they do not provide the decision-maker with all the relevant information. There is anargument for presenting the entire probability distribution directly to the decision-maker. Such an approach isappropriate when management must select one from a small number of alternatives, but in situations wheremany alternatives need to be considered the examination of many probability distributions is likely to bedifficult and time-consuming. In such situations management may have no alternative but to compare theexpected values and coefficients of variations.
DecisionDecisionDecisionDecision treetreetreetree analysisanalysisanalysisanalysisIn practice, more than one variable may be uncertain (e.g. sales and costs), and also the value of some variablesmay be dependent on the values of other variables. Many outcomes may therefore be possible, and someoutcomes may be dependent on previous outcomes. A useful analytical tool for clarifying the range ofalternative courses of action and their possible outcomes is a decision tree.
A decision tree is a diagram showing several possible courses of action and possible events (i.e. states of nature)and the potential outcomes for each course of action. Each alternative course of action or event is represented bya branch, which leads to subsidiary branches for further courses of action or possible events. Decision trees aredesigned to illustrate the full range of alternatives and events that can occur, under all envisaged conditions. Thevalue of a decision tree is that its logical analysis of a problem enables a complete strategy to be drawn up tocover all eventualities before a firm becomes committed to a scheme. Let us now consider Example 2. This willbe used to illustrate how decision trees can be applied to decision-making under conditions of uncertainty.
Example 2A company is considering whether to develop and market a new product. Development costs are estimated to be$180000, and there is a 0.75 probability that the development effort will be successful and a 0.25 probabilitythat the development effort will be marketed, and it is estimated that:
1. If the product is very successful profits will be $5400002. If the product is moderately successful profits will be $1000003. If the product is a failure, there will be a loss of $400000
Each of the above profit and loss calculations is after taking into account the development costs of $180000. Theestimated probabilities of each of the above events are as follows:
1. Very successful 0.42. Moderately successful 0.33. Failure 0.3
TutorialTutorialTutorialTutorial QuestionQuestionQuestionQuestionFirlands Ltd., a retail outlet, is faced with a decision regarding whether or not to expand and build small orlarge premises at a prime location. Small premises would cost $300000 to build and large premises would cost$550000.
Regardless of the type of premises built, if high demand exists then the net income is expected to be $1500000.Alternatively, if low demand exists, then net income is expected to be $600000.
If large premises are built then the probability of high demand is 0.75. If the smaller premises are built then theprobability of high demand falls to 0.6.
Firlands has the option of undertaking a survey costing $50000. The survey predicts whether there is likely tobe a good or bad response to the size of the premises. The likelihood of there being a good response, fromprevious surveys, has been estimated at 0.8.
If the survey indicates a good response then the company will build the large premises. If the survey does givea good result then the probability that there will be high demand from the large premises increases to 0.95.
If the survey indicates a bad response then the company will abandon all expansion plans.
As a business, we invest in both fixed assets and current assets. Investment in fixed assets representsinvestment in long term investments and to be evaluated using the capital budgeting techniques. Whereasinvestments in current assets are short term investments and are to be evaluated using working capitalmanagement tools.
In Capital Budgeting, three steps are involved:(1) Estimation of cash flows(2) Analysis(3) Decision making
Estimation of cash flows – using cash budgetsOnly relevant cash flows arising or associated with the investment should be included, duly adjusted for theeffects of taxation and inflation if appropriate.
Schedule of net cash flowsTime T0 T1 T2 T3 T4
Cash inflows
Sales - x x x xDisposal proceeds x - - - -
Cash outflowsInitial outlay x - - - -Mat, lab, OH - x x x xTax payable - - x x xS&D etc. - x x x xNet cash flow (x) x x x x
Types of cash flows for investment appraisal:1. Operating cash flows – includes all income statement items except non-cash items and non-trading items.
This is used for tax calculation purposes later.
2. Tax cash flows – include tax payable and tax savedTax payable – calculated based on operating cash flowsTax saved – based on capital allowance on qualifying capital expenditure
3. Investment cash flowsInvestment and disposal of fixed assetsInvestment and recovery of working capital
4. After-tax cash flows – treated like investment cash flows otherwise we double count the tax.
5. Financing cash flows – include interests, dividends, issuing costs, redemption premium, received andrepayment etc. [all these are NOT relevant for investment appraisal]
Analysis: Analysis are in four main areas:- How fast can the capital be recovered?- How much profit can we make?- What is the rate of return on investment?- How would this profit be affected if there is a change in the cost of money?
Decision makingAfter all this analysis and all others surrounding circumstances being considered, a decision can be madewhether to accept any of the project or not.When considering whether a project is worthwhile, the management must consider its implications like:a) The effect on the liquidity of the company. Since all projects involve cash inflows and outflows with
different sizes and timing. They must be considered to ensure that there is always sufficient cash in thecompany to meet the daily payments and dividends.
b) The effect on reported profit and earnings. All projects will change the revenues, expenses and assets valuesshown in the financial accounts. Then due care must be taken to ensure that the effects on short-term profitshould be minimised to protect the shareholders interest.
c) The effect on variability of cash flows and earnings. Investment decision can have an impact on the cashflow position of the company and causes cash flows to fluctuate or to stabilise the cash flows. If it causesfluctuation, then the greater the variability, the greater the risk and higher return will be required by investors,causing the cost of capital to rise in the long term or share price to fall. Therefore the effect on the overallriskiness of the business must also be considered before an investment decision can be made.
Payback period analysisPayback period analysis is concerned about how fast the money invested can be recovered by the cash flowsgenerated by the project, including investment in working capital. Its purpose is to avoid the company fromaccepting high risk projects, because projects with longer payback period are riskier as cash flows estimates inthe future years has a greater tendency to be wrong than those arising in the earlier years.
Payback period = Year before payback + Cumulative net cash flow before payback
Cash flow in the year of payback
Advantages of payback:- Simple to compute, easy to explain and understand- It uses cash flows and not profits, and will not be distorted by assorted accounting conventions- It is a rough measure of risks, i.e. fast payback is less risky, therefore minimise risk to the company- Rapid payback also maximise cash flows and accelerate growth of the company by reinvesting in profitable
investment- It is particularly useful in environment where technology changes very fast then a quick payback is essential
before the investment in plant is obsolete.
Limitations of payback:- It does not take into account the time value of money- It ignores cash flows after payback, i.e. both the returns and profitability are ignored- It lacks objectivity and cannot give a decision. Even if a standard is set by the company in order to compare
with the payback periods of different projects, only ranking of projects is possible but decision still cannotbe made.
Other uses of payback period:a) Discounted payback – where the payback period is calculated based on the discounted cash flows and taking
into account the time value of money. Even if it is still ignoring cash flows payback, but it is useful in mostcircumstances especially when the NPV of projects are positive. In this case it will always provide a similaraccept and reject decision as NPV criterion even though the ranking may be different.
Discounted payback = Year before payback + Cumulative PV before paybackPV of CF in year of payback
b) Payback reciprocal – the reciprocal of the payback period expressed as a percentage, in certaincircumstances approximates the IRR of the project, and helpful in determining the acceptability of a project.
Net present value (NPV)This is the sum of PV of cash inflows and PV of cash outflows.NPV = PV of cash inflows + PV of cash outflows
The significance of NPV is that it represents the amount by which there will be an immediate increase inwealth of the company’s shareholders. If the company is listed / quoted on the Stock Exchange, then underperfect market condition, the NPV is the amount by which the total value of all issued shares is expected toincrease by.
Those cash flows arising in the future that has been adjusted for the cost of money is termed present value.
NPV is the immediate increase in wealth resulting from acceptance of a project. It is the amount, over and abovethe cost of the project that you can borrow and know that the cash flows from the project will repay the wholeloan.
Advantages of NPV:- It is an absolute measure of cash flow surplus and therefore not distorted by any mathematical analysis- It takes into account the time value of money when discounting the cash flows at the basic capital- The discount rate used in order to arrive at the NPV may be enhanced by incorporating the effects of tax,
inflation and risk, and may be computed on an off-the-text basis
Limitations of NPV:- Its accuracy depends on a very large extent the accuracy of its components- It’s sometimes difficult to explain to non-financial managers
- Practically, it may not be possible to compute the NPV until the cost of capital figure is known, but theinformation relating to the determination of cost of capital will become available only after the treasurydepartment had been given an indication of the likely level of investment of the forthcoming period
Why time value money is important?The reasons for time preference are:(a) Consumption preference – money received now can be spent on consumption(b) Risk preference – risk disappears once money is received(c) Investment preference – money received can be invested in the business, or invested externally.
Profitability index (PI)PI is a measure of profitability of an investment by comparing the NPV with the capital invested.
PI = NPV / Capital invested or PV of inflows / PV of outflows
Advantages of PI:- It takes into account the time value of money when utilising present values in its calculation.- It is expressed in term of percentage and therefore most managers can relate to it.- It examines the profitability on investment and not just profit and therefore useful in situation of capital
rationing.
Limitations of PI:- It is a relative measure and therefore not suitable in ranking mutually exclusive projects of different sizes.- It is not suitable to be used in making decision under multi-periods capital rationing situation.- It suffers from the same problem as NPV in the determination of suitable discount rate to be used in
calculating present value.
Internal rate of return (IRR)The IRR measures the sensitivity of NPV to changes in the cost of capital. It is that discount rate at which theNPV will become zero. The decision criteria under IRR is to accept projects so long as their IRR are higher thanthe company’s cost of capital.
IRR = Discount rate + NPV at that discount rate1% change
Advantages of IRR:- It is expressed as a percentage and therefore most managers can relate to it.- It does not need the cost of capital value initially for it to be computed.- It provides a rough measure of risk because it represents the buffer between the project cash flows and the
company cost of capital. It therefore measures the sensitivity of the NPV to changes in the discount rate.
Limitations of IRR:- It is a relative measure and therefore not suitable in ranking mutually exclusive projects of different sizes.- The IRR for certain type of cash flows are capable of more than one result because the IRR equation is
polynomial, and this makes it difficult to interpret the cut-off of break-even. This may be overcome bycomputing the extended yield of IRR.
- The IRR cannot cope with interest changes.- Some patterns of cash flows do not have an IRR.- It is relatively insensitive to changes in the discount rate and will provide the same answer in spite of
fluctuation and therefore, may provide a different ranking with the NPV calculation especially the cash flowsprofiles of different projects intersect.
Procedures for calculation of extended yield of IRR:- Prepare the schedule of net cash flows as usual- Discount only future negative cash flows at the cost of capital- Add the present value of these negative cash flows to the initial outlay- Rewrite the net cash flow schedule
- Compute the IRR as usual
To evaluate projects with different lives or different discount ratesFor projects with different lives, then to calculate the present value of all cash flows and divide them using theannuity factor to determine the annual equivalent cash flow.
AEC = NPV / Annuity factor
For projects with different discount rate, discount the annual equivalent cash flows until infinity to make adecision.
PV to infinity = AEC / Discount rate
Relevant cash flows for investment appraisal(a) Past costs – those costs incurred in the past
If without alternative and no recovery value or scrap value, is also called sunk cost and is not relevant. Butthose with a recovery value or scrap value then the scrap value is relevant. If with alternative use but not ascarce resource, then the replacement cost is relevant. Also, if it is a scarce resource, then the original costand opportunity cost is also relevant.
(b) Future costs – those costs to be incurred in the futureFuture variable costs are always relevant unless committed or contracted. Future fixed costs are alwaysirrelevant especially allocations and apportionment unless specific or incremental fixed costs. Futurecommon costs are those that will always be incurred irrespective of alternative chosen and is not relevantunless in mutually exclusive financial decision.
Accounting rate of return (ARR)The ARR is also sometimes called the Return on Capital Employed. It expresses the profits from a project as apercentage of capital cost.
ARR = Average annual profits after depreciation before interest x 100%Initial capital cost or Average capital cost
Advantages of ARR:1. It is expressed as a percentage and therefore most managers can relate to it.2. It is simple to calculate, easy to explain and understand.3. Accounting information is easily and cheaper to obtain.4. Accounting principles and concepts can be more easily understood and accepted.5. It takes into accounts the capital cost of project by relating return to investment costs.6. It relates the return on the project to other accounting information and ratios.
Limitations of ARR:1. It does not take into accounts of the timing of cash flows and the time value of money.2. Accounting policies are not consistent for different firms.3. Accounting information does not consider the relevancy of costs and revenue.4. It ignores the working capital requirements.5. Variations of formulas exist and no one absolute consistent and accurate formula.6. It cannot give a decision.
Net terminal value (NTV)To calculate the terminal value of the project, i.e. to calculate the cumulative future cash flows after deductingthe investment costs when we terminate the project at the end of the project life. This can be calculated bycompounding all the cash flows by the relevant cost of capital until the end of project life. This is particularlyuseful if the management wants to know the cumulative cash flows after the end of project to undertake otheractivities.
Future value (FV) = Cash flows (1 + r) n and NTV = NPV (1 + r) n or NPV = NTV / (1 +r) n
Modified Internal Rate of Return
Modified IRR can be calculated to determine the actual IRR of a project especially useful in situation where theproject has more than one IRR because modified IRR calculation will only result in one IRR.
The advantages of modified IRR are:1. It eliminates the confusion created by two IRR because modified IRR can obtain only one result.2. The assumption is better – Normal IRR assumed we can re-invest cash flows earned from a project at the
IRR; this is unlikely to be true because we are not going to invest the cash flows we earned from a projectinto the same project but may be into other project. Whereas modified IRR assumed that we can re-invest thecash flows we earned from a project at the company’s cost of capital. This is more reasonable because thereturns from any new project will be return to the company to be used for other investments.
Modified IRR combines the advantages of IRR and NPV into a single calculation, and is claimed to be a moresuperior method than other investment appraisal techniques; however it is rarely used by companies in practice.
Adjustment for tax effects:Tax normally has two effects on capital budgeting.- Incremental cash flows earned by the project will attract extra tax liability (cash outflow).- The qualifying capital expenditure will have tax saved on capital allowances (cash inflow).
The effects of tax are very complex, for example:- The taxable profits and tax rate;- The company’s accounting period, and tax payment dates;- Amount s paid as Advance corporation Tax (ACT)- Capital allowances;- Losses available for set-off or not.
Unless information to the contrary, the following assumptions should be adopted:- All tax effects are assumed to arise one year in arrears unless question stated otherwise;- Taxable profits are net project operating cash flows, and current tax rate applies;- Ignore ACT;- Assume sufficient taxable profits in other areas of the company to absorb the taxable losses arising from the
project;- The investment is made at the beginning of the year 1 so that the CA is claimed at the end first year and first
tax saved will start in year 2.
Adjustment for inflation effects:Inflation is a fall in value of money. It is of critical importance to the capital budgeting process because thecapital outlay is quite often immediate with the cash inflows being earned over the project life. The estimationof cash flows can be distorted if the different variables in the capital budget are affected by different rates ofinflation.
This may be overcome by compounding the cash flows in the original capital budget at the specific rates ofinflation that affect each items of revenue and expenditure, and then discount these money cash flows using themoney cost of capital.
The cash flows estimates in the original budget are stated in terms of current prices, these are called real cashflows, once adjusted for the effects of inflation they are called money cash flows.
Note that some cash flows will never be affected by inflation for example cash flows arising immediately likedisposal proceeds, initial investment etc., and committed cost or contracted costs.
Fisher effect: (1 + RCC) (1 + F) = (1 + MCC)
Note 1: Cash flows can be given in year 0 or year 1 prices.
Note 2: Always use money cash flows and money cost of capital unless:-
Example
Trevor Co plans to buy a new machine to meet expected demand for a new product, Product T. This machinewill cost $250000 and last for four years, at the end of which time it will be sold for $5000. Trvor Co expectsdemand for Product T to be as follows:
The selling price for Product T is expected to be $12.00 per unit and the variable cost of production is expectedto be $7.80 per unit. Incremental annual fixed production overheads of $25000 per year will be incurred. Sellingprice and costs are all in current price terms.
Selling price and costs are expected to increase as follows:
IncreasesIncreasesIncreasesIncreasesSelling price of Product T: 3% per yearVariable cost of production 4% per yearFixed production overheads 6% per year
Other information:Trevor Co has a real cost of capital of 5.7% and pays tax at an annual rate of 30% one year in arrears. It canclaim capital allowances on a 25% reducing balance basis. General inflation is expected to be 5% per year.
Trevor Co has a target return on capital employed of 20%. Depreciation is charged on a straight line basis overthe life of an asset.
TutorialTutorialTutorialTutorial QuestionQuestionQuestionQuestionQ1. Duo Co needs to increase production capacity to meet increasing demand for an existing product, ‘Quago’,which is used in food processing. A new machine, with a useful life of four years and a maximum output of600000 kg of Quago per year, could be bought for $800000 payable immediately. The scrap value of themachine after four years would be $30000. Forecast demand and production of Quago over the next four yearsis as follows:
YearYearYearYear 1111 2222 3333 4444Demand (kg) 1.4 million 1.5 million 1.6 million 1.7 million
Existing production capacity for Quago is limited to one kilogram per year and the new machine would only beused for demand additional to this.
The current selling price of Quago is $8.00 per kilogram and the variable cost of materials is $5.00 per kilogram.Other variable costs of production are $1.90 per kilogram. Fixed costs of production associated with the newmachine would be $240000 in the first year of production, increasing by $20000 per year in each subsequentyear of operation.
Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital allowances (tax-allowabledepreciation) on a 25% reducing balance basis. A balancing allowance is claimed in the final year of operation.
Duo Co uses its after-tax weighted average cost of capital when appraising investment projects. It has a cost ofequity of 11% and a before-tax cost of debt of 8.6%. The long-term finance of the company, on a market-valuebasis, consists of 80% equity and 20% debt.
Q2. SC Co is evaluating the purchase of a new machine to produce product P, which has a short product life-cycle due to rapidly changing technology. The machine is expected to cost $1 million. Production and sales ofproduct P are forecast to be as follows:
The selling price of product P (in current price terms) will be $20 per unit, while the variable cost of the product(in current price terms) will be $12 per unit. Selling price inflation is expected to be 4% per year and variablecost inflation is expected to be 5% per year. No increase in existing fixed costs is expected since SC Co hasspare capacity in both space and labour terms.
Producing and selling product P will call for increased investment in working capital. Analysis of historicallevels of working capital within SC Co indicates that at the start of each year, investment in working capital forproduct P will need to be 7% of sales revenue for that year.
SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax is reduced bycapital allowances on machinery (tax-allowable depreciation), which SC Co can claim on a straight-line basisover the four-year life of the proposed investment. The new machine is expected to have no scrap value at theend of the four-year period.
SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.
Capital Structure Theory is concerned about the appropriate mix of financing of a business. It discusses on howmuch of the company’s capital should come from the equity shareholders and how much of the capital should beraised through borrowing which described the relationship between debt and equity using gearing ratio.
Gearing is said to exist whenever a company is financed partly by borrowing. Borrowing will create a fixcommitment to service interest whether profit is being made or not. This magnifies the fluctuation in theresidual profits available for distribution to the equity shareholders i.e. they become more risky. The increase inrisk due to financing is called financial risk. It is to be distinguished from systematic business risk which everybusiness is affected by however it is financed.
There are two different theories on capital structure:-a) Modigliani & Miller view (or net operating income view)b) Traditional View (or net income view)
In 1958, Modigliani & Miller (M&M) put forward a static, tax free, partial equilibrium valuation theory. Theirargument was that the total value of the company was determined by:-(i) It’s net operating income, and(ii) The level of business risk attached to that income
M&M further stated that no advantage or disadvantage can be gained from gearing as WACC is unaffected bythe debt and equity ratio i.e. there is no optimum capital structure.
(1) The cost of debt, equity & WACC under the M&M no-tax model (graph).
(2) Value of the firm under the M&M no-tax model (graph).
Note- The cost of debt remains unchanged as gearing is increased.- The cost of equity rising in a manner that leaves the WACC always constant due to a capital arbitrage.
Arbitrage is a process of selling shares in a company with the lower value of WACC (overvalued company) andbuying shares in the company with the higher value of WACC (undervalued company).
Assumptions of Modigliani & Miller1. Capital markets are perfect and in equilibrium.2. Investors are rational and risk averse.3. No transaction cost.4. No bankruptcy cost.5. All investors have similar expectation about the future.6. No limited liability.7. Personal borrowing is having same cost as corporate borrowing.8. Firms can be grouped into similar risk classes.
Criticisms of Modigliani & Miller1. Market imperfection are deep-rooted and systematic, therefore equilibrium will not be achieved.2. There is substantial amount of transaction costs involved in the arbitrage process.3. Personal borrowing is not the same as corporate borrowing because of the limited liability enjoyed by
companies where it may be better for the company to borrow rather than an individual to borrow on its ownaccount.
4. Corporate borrowings do not have the same cost as personal borrowing because corporate borrowing oftenenjoys better terms.
5. It is unlikely that the cost of debt will remain constant especially when the gearing is becoming too high andinstitutional investors may be reluctant to lend money beyond certain gearing ratio.
6. If the cost of debt were to increase at extreme level of gearing, the cost of equity must drop so that WACCremains constant which is impossible to occur.
7. The effects of tax is ignored which can further affect the cost of borrowing because corporate borrowing isalways tax deductible and is not the case for individuals.
In 1963, Modigliani & Miller revised their earliest conclusion to admit that the existence of taxation and taxallowances on interest does lower the cost of borrowing but the cost of capital will continue to drop up to 99%gearing.
Modigliani & Miller with tax (graph)
Value of the firm, Modigliani & Miller with tax
A geared company in the same risk class with the same level of pre-tax profit will have a higher value than anungeared company because of the present value of tax saved on interest on borrowing.
Reasons why companies cannot have 99% gearing1. Institutional investors may be reluctant to lend any further money beyond certain level of gearing.2. The company may exhaust its corporate tax liability short of 99% gearing, i.e. for company that cannot take
advantage of the tax saved, and then the tax shield should be reduced accordingly.3. Because of personal tax where the tax on interest income may be too high, i.e. if the tax saved on debt
interest by the company is less than the tax payable by investors, the increase in gearing is not worthwhile.4. Agency costs will increase as gearing increases which may be higher than the tax shield obtained from the
extra debt financing.5. The implication of bankruptcy costs (i.e. the expected present value of cost of financial distress) may be too
high due to greater risk of bankruptcy.
ConclusionThe Traditional View concludes that a company should borrow at the optimum borrowing ratio but in practice,it is very hard if not, impossible to tell what is the optimum borrowing ratio whereas Modigliani & Millerconcludes that a company should borrow as much as possible as long as it is acceptable to the equityshareholders. The compromise between Traditional View and Modigliani and Miller Theory is that, the extremelevel of gearing is to be ignored which is unlikely to give rise to minimum cost of capital. If a company isfinanced wholly by equity, it will lose out the opportunity of using some cheap sources of debt financing. If thecompany is too highly geared, the increase in the financial risk will increase the cost of capital which will beundesirable. Therefore, in between the extreme, there is probably a very broad area where the optimum gearingwill lie. Therefore, financial managers should seek based on experience where it is.
The current view by Brealey and Myers is that the amount a company can borrow will depend on:1. The level of healthy profit (cash flows) that can be generated by the company.2. The amount of strong asset base as collateral.3. The view of the providers of capital as to the acceptable level of gearing.4. The size of the organization.5. The tax position of the company.6. Countries in which the fund will be invested and borrowed.7. Organisation’s perception of its debt capacity, based on its ability to repay such debt.
In traditional view, since debt financing is cheaper than equity finance (because interest paid on debt is taxdeductible), then a company should introduce borrowing into its capital structure so that the WACC will belower due to the introduction of cheap debt into the capital structure, but if the company increase the borrowingto a higher level which is believed to be too high, then the cost of debt will increase and the cost of equity willalso increase due to the higher level of financial risk. A finance manager should therefore push the gearing atthat level just before the overall cost of capital is increasing.
The cost of capital and the value of the firm with taxes and financial distress as gearing increases (graph) isshown as below:-
From the graph, the following points can be observed:-1. If the company is all equity financed, the cost of capital will be equal to the cost of equity.2. Since debt financing is cheaper, the company will introduce borrowing into its capital structure and this does
not have an effect on both the cost of debt and cost of equity but the WACC will drop due to the introductionof cheap debt capital into the capital structure. It also reflects the fact that the market will not react andadjust immediately for the increase in financial risk.
3. As the company’s gearing increases, the equity shareholders will re-appraise the risk of the company due tothe increase in financial risk, and then the cost of equity will increase.
4. After a period of time which is not related to the equity time zone, the lender of debt financing will also re-appraise the risk in the business and the cost of debt will also increase.
5. The finance manager should therefore monitor the pace of increase in cost of debt, cost of equity and theoverall cost of capital and maintain the gearing at that particular level just before the cost of capital increases.
6. In traditional theory, it is believed that the cost of equity and cost of debt is independent of each other andthat every company has an optimum capital structure. At that point the cost of capital is minimized and thevalue of company is maximized i.e. the shareholders’ wealth are maximized.
ExampleNewly Established Plc has recently been formed to take advantage of a major investment opportunity which willcost $10 million, and is expected to generate annual profits of $1.2 million. The company therefore wishes toraise $10 million, and has consulted you as to the proportion which should be raised through ordinary shares anddebentures respectively.
After discussions with financial analysts, you have ascertained that the cost of capital of the company woulddepend upon its capital structure as follows:
Gearing Cost of equity Cost of debenturesPercentage percentage (net of tax) percentage
Required:(a) Calculate the weighted average cost of capital for the company at each of the above prospective levels of
gearing.
(b) Calculate the earnings per share and the expected market value of each $1 share to be issued by the companyat each of these levels of gearing.
(c) Identify the optimal capital structure for the company and discuss the value of using information of this sortfor such a purpose.
TutorialTutorialTutorialTutorial QuestionQuestionQuestionQuestionEastwell Plc is to be established shortly. The founders are considering their options with regard to capitalstructure. A total of $1 million will be needed to establish the business and the three ways of raising these fundsbeing considered are:
(a) Selling 500,000 shares at $2.00(b) Selling 300,000 shares at $2.00 and borrowing $400,000 with an interest rate of 12 %.(c) Selling 100,000 shares at $2.00 and borrowing $800,000 at an interest rate of 13%.
There are three possible outcomes for the future annual cash flows before interest:
Success of product Cash flow before interest ProbabilityPoor $60,000 0.25Good $160,000 0.50Excellent $300,000 0.25
Note: Taxes may be ignored
Required:(a) Calculate the expected annual return to shareholders under each of the capital structures.(b) Calculate the standard deviation of the expected annual return under each of the capital structures.
• SavingsSavingsSavingsSavings AccountsAccountsAccountsAccountsSavings accounts are a safe haven to store your emergency funds. They provide easy access to your money andare generally insured. If you or your family’s deposit accounts at one FDIC-insured bank or savings associationtotal $100,000 or less, your funds are fully insured. The chief drawback of such accounts is that interest ratestend to be low since they offer a very high degree of safety.
• CDsCDsCDsCDs (Certificates(Certificates(Certificates(Certificates ofofofof Deposit)Deposit)Deposit)Deposit)A CD is a special type of deposit account that typically offers a higher rate of interest than aregular savings account. Just like savings accounts, CDs are also insured up to $100,000.When you purchase a CD, you invest a fixed sum of money for fixed period of time. Usually,the longer the period, higher is the interest rate. There are penalties for early withdrawal.
• MoneyMoneyMoneyMoney MarketMarketMarketMarket DepositDepositDepositDeposit AccountsAccountsAccountsAccountsThese accounts generally earn higher interest than savings accounts. They are very safe andprovide easy access to your money. They are also insured by the FDIC. They offer many ofthe services that checking accounts offer, however, a limit is normally placed on the numberof withdrawals or transfers you can make during a given period of time.
• StocksStocksStocksStocksWhen you buy stocks, you own a part of the company’s assets. If the company does well, youmay receive periodic dividends and/or be able to sell your stock at a profit. If the companydoes poorly, the stock price may fall and you could lose some or all of the money youinvested.
• BondsBondsBondsBondsA bond is a certificate of debt issued by the government or a company with a promise to paya specified sum of money at a future date and carries interest at a fixed rate. Bond terms canrange from a few months to 30 years. Bonds are tradable instruments and are generallyconsidered a safer than stocks because bondholders are paid before stockholders if acompany becomes bankrupt. Independent bond-rating agencies rate the likelihood that anygiven bond will default.
• MutualMutualMutualMutual FundsFundsFundsFundsA mutual fund is generally a professionally managed pool of money from a group ofinvestors. A mutual fund manager invests your funds in securities, including stocks andbonds, money market instruments or some combination of these, based upon the fund’sinvestment objectives. By investing in a mutual fund you can diversify, thereby, sharplyreducing your risk. Most mutual funds charge fees. You often pay income tax on your profits.
• AnnuitiesAnnuitiesAnnuitiesAnnuitiesAnnuities are contracts sold by an insurance company designed to provide payments to theholder at specified intervals, usually after retirement. Earnings cannot be withdrawn withoutpenalty until a specified age and are taxed only at the time of withdrawal. Annuities arerelatively safe, low-yielding investments. An annuity has a death benefit equivalent to thehigher of the current value of the annuity or the amount the buyer has paid into it.
There are many kinds of financial instruments in the foreign exchange market that are widelyused today.
1. FuturesFuturesFuturesFutures - This is the type of currency that is defined as forward transactions that havestandard sizes as well as dates of maturity. One example is 500,000 British pounds for nextDecember at a rate previously agreed upon. The Futures have been standardized and usuallythey are traded on the exchange rates created for such purpose. The contract has an averagelength of 3 months roughly. The contracts usually include interest of any amount.
A FuturesFuturesFuturesFutures ContractContractContractContract is an agreement to buy or sell any commodity on some future date at aprice agreed today.
A futures contract is similar to the forward contract except that it is standardised as to the:(a) Amount(b) Quality, and(c) Delivery dates – end of March, June, September and December
Futures are traded at the London International Financial Futures Exchange (LIFFE). A special feature of futuresis that they are not specifically designated for specific transaction and therefore readily marketable. However, inthe case of privately negotiated contract, it may not be possible to transfer the contract to another party; on thefutures market this may be possible.
Buying a futures contract commit the firm to buy certain commodity at a specified price on some date in thefuture.
Selling a futures contract commit the firm to sell certain commodity at a specified price on some date in thefuture.
Buying a currency futures commit the firm to buy certain units of a currency at a specified rate on some date inthe future.
Selling a currency futures commit the firm to sell certain units of a currency at a specified rate on some date inthe future.
A UK firm will take a position in the future market such that if the event that it fears on atrader occurs, it will make a gain as a future dealer.
The firm will make a gain when price of goods rises if it bought a futures contract, before theprice rises.
The firm will make a gain when price of goods falls if it sold a futures contract, before theprice falls.
In summary to the above, a futures price incorporates the market’s belief about the likelymovement of an asset’s underlying price.
A futures contract is entered into through an organised exchange, using banks and brokers.These contracts are settled through organised exchanges and they have clearing houses,which may be financial institutions or part of the futures exchange. The clearing houses act
as intermediaries between the buyer and the seller, guarantee obligations and make futuresliquid with low credit risk.
Futures contracts are used to hedge the entire price change of a commodity, a foreigncurrency or a financial instrument since the contract value and underlying price changesymmetrically. The settlement price of a futures contract converges towards the futures priceon the delivery date.
The following are the key features of a futures contract:� Traded on an organised exchange� Standardised contract� Agreement to buy or sell an underlying asset at a specified price sometime in the future� Margin requirements ranging from 5% to 10% of the face value of the contract� Presence of clearing houses which act as intermediaries between the buyer and seller
FuturesFuturesFuturesFutures terminologyterminologyterminologyterminologySpot price is the price at which an underlying asset trades in the spot market.Futures price is the price at which the futures contract trades in the futures market.Contract cycle is the period over which a future contract trades. Depending upon the nature of the instruments,futures contracts may have one-month, two-month or three-month expiry cycles.Expiry date is the date specified in the futures contract. This is the last day on which the contract will be traded,at the end of which it will cease to exist.Contract size is the amount of asset that has to be delivered under one contract. This is also known as lot size.Cost of carry is the relationship between futures prices and spot prices that can be summarised in terms of whatis known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset lessthe income earned on the asset.
2. ForwardForwardForwardForward TransactionTransactionTransactionTransaction - Another way to deal with the risk of the Foreign exchange is todeal in a transaction termed as forward transaction. In this type of transaction, one's moneydoesn't change the hands actually not until there is an agreed upon date in the future. Thebuyer and the seller agree on an exchange rate for a date anytime in the future, and the dealoccurs on that particular date, and this is regardless of what the rates in the market would bethen. Duration of trading could be carried out in a few days, months and even years.
Forward transaction is also known as forward contract. A forward contract is defined as an agreement madetoday between a buyer and seller to exchange a specified instrument for a specified quantity at a predeterminedfuture date, at a price agreed upon today.
The specified instrument could be a commodity, currency or other underlying asset. The price agreed is calledthe “forward rate”. The forward rate is determined at the time of entering into the contract but the settlement ofthe contract happens at a future date mentioned in the contract.
The following are the key features of a forward contract:� It is a bilateral contract and hence exposed to counterparty risk� The contracts are not traded and hence the contract price is generally not available in the public domain.� Each contract is custom-designed and hence is unique in terms of contract size, time to expiry and
underlying asset.� On the date of expiry, the contract has to be settled by delivery of the underlying asset.� It can hedge the risks relating to currency exposure risk (forward contracts on Euro or dollar) or commodity
prices (forward contracts on crude oil, rubber, coffee etc)
Forward contracts are often used to hedge adverse movements in currencies, commodity or a financialinstrument, irrespective of whether the price increases or decreases. For example, if a party expects anappreciation in the currency rate in which he is required to pay in future, he can enter into a forward contract to
protect him from loss on account of foreign exchange fluctuation. Foreign currency forward contracts are usedas a foreign currency hedge when an investor has an obligation to either make or receive a foreign currencypayment at a future date. In a forward contract, no part of the contract is standardised and the two parties meetand agree every detail of the contract before signing it.
3. SpotSpotSpotSpot - This type of transaction is defined by its two-day delivery which when compared tothe future type of contracts that have the duration of usually three months. The spot traderepresents the "direct exchange" between two kinds of currencies. The spot has the shortestlength of time. It involves money or cash rather than the contract. The interest is exclusive inthe agreed transaction. The spot market is the source for the data of this study.
4. SwapSwapSwapSwap - This is the most common kind of forward transaction. The currency swap consistsof two parties exchanging currencies for a period of time. The two parties agree to reversethe trade at a certain later date. The Swap however is not considered as contracts and swapsare not traded through the exchange.
In other words, a swap can be defined as a bilateral OTC (over-the-counter) derivative contract in which twoparties exchange one stream of future cash flows for another stream of cash flows over a period of time. One ofthese parties is usually the bank or a financial institution. These streams are called the legs of the swap. The cashflows are calculated over a notional principal amount. Swaps are often used to hedge certain risks, for instanceforeign currency rate risk. Swaps are mainly classified as currency swaps and interest rate swaps. A swap, initself is neither borrowing nor lending. The size of the swap is referred to as the notional amount and is the basisfor calculation.
IntroductionIntroductionIntroductionIntroductionWorkingWorkingWorkingWorking capitalcapitalcapitalcapital refers to the current assets that are maintained by a business to allow for smooth businessoperation. Net working capital is the value of current assets less the current liabilities in any given period; itrepresents that part of current assets which is financed by long-term finance.
ObjectiveObjectiveObjectiveObjective
Working capital management is used to refer to the management of all aspects of both current assets and currentliabilities, to minimise the risk of insolvency while maximising the return on assets. Typically current assetsrepresent more than half of assets of companies; they tend to be of particular importance to small firms.
Working capital management requires decisions to be made in two areas:- Determining the level of investment in individual components of working capital, i.e. stock levels, credit
policy and cash balances.- Determining the approach to an appropriate mix of financing to such investment
Financing strategy for working capitalFirms may adopt one of the three approaches to the financing of working capital:(a) Matching concept(b) Conservative approach(c) Aggressive approach
MatchingMatchingMatchingMatching ApproachApproachApproachApproachMost firms should normally attempt to identify the long-term investment in the company. This comprises thefixed assets and permanent current assets. The total investment must then be matched and equated with the long-term sources of finance which usually are:- Retained earnings- Bank loans- New issue of securities either shares or debentures
Seasonal variation in selling activity may cause stock and debtors’ balances to fluctuate. These fluctuations maybe financed by short-term finance and stand-by credits. Examples:- Overdrafts- Letter of credit for trade financing- Bankers’ acceptances- Other money markets borrowing- Trade credits
ExampleExampleExampleExample(a) WC Ltd has projected the following balances for its current assets over the next two years.
$’000Now 2350Year 1 Q1 2550
Q2 2950Q3 2750
Year 2 Q1 2800Q2 3350Q3 2700Q4 2500
Fixed assets currently stand at $1.5 million and are expected to increase by 20% over the eight quarters.
Required:How much additional financing is required for long-term and what is the total amount of standby credit required?
(b) Additional information:Retained earnings will be 55% of profits after taxProfits after tax Year 1 $0.4 million
Year 2 $0.6 million
Required:How much will be required to be raised through bank loans?
When a company is able to accumulate long-term funds (usually from retained earnings) and does notimmediately wish to repay any existing long-term borrowing, it may lead the long-term money in the business tohelp part finance of the fluctuating current assets. This would obviously result in time period where the firmwould have surplus funds. Good finance manager should make an effort to invest this money in marketablesecurities or callable money, for example, on the money market or Europe market.
A company may adopt a more aggressive approach in financing by using short-term and standby credit tofinance not only the fluctuating current assets, but also part of the permanent current assets. Such a strategy maybe used during time when short-term finance is relatively cheaper than long-term finance. Another reason forsuch approach can occur when the company is anticipating a large amount of cash flows that can be generatedfrom operations and therefore expecting such excess short-term finance can be repaid easily without affectingthe liquidity of the company.
Decision relating investment levelsThe other aspect of working capital management is to answer question such as:
- the optimal stock level- the credit policyThat can maximise contribution and requirement of cash balances from time to time.
Inventory controlFirms need to maintain stocks for the following reasons:- to prevent stock-out by meeting unexpected fluctuation in demand- to take advantage of quantity discount- to fulfil transport requirement of supplier, for example, usage of one complete container- as a hedge against potential increase in price- to lend smoothness to business operation
The costs involved are in two main areas:(a) Total Carrying Costs (TCC)- Rental and maintenance of warehouse- Staff salary- Insurance- Interest cost of capital tied up in stock- Obsolescence cost- Pilferage cost(b) Total Ordering Costs (TOC)- Transportation and material handling cost- Insurance during transport- Administrative cost of issuing purchase requisition and receiving supply- Cost of stock return
The traditional view has been to equate the ordering costs with the carrying costs to arrive at the lowest possibletotal inventory cost. It has been believed that this can be achieved by identifying a batch size or order quantitythat will equate TOC with TCC to arrive at the optimal TIC.
Assumptions of EOQ- Sales can be predicted with reasonable accuracy- Sales are evenly distributed throughout the year and not seasonal- The carrying cost of stock are all variable- The ordering costs are fixed irrespective of the size of the order- There is no lead time in delivery of the stocks
If there is no safety stock
EOQ = 2DO/h
Where D is the demand per annumO is the fixed cost per orderh is the holding cost per unit for a yearh = cost per unit x storage cost %
TOC = NO where N is the number of orders p.a. = D/Q; TOC = DO/QTCC = hA where A is the average stock value = Q/2; TCC = hQ/2TIC = TOC + TCCROL = Lead time x demand
If there is safety stockEOQ = 2DO/hTOC = DO/QTCC = hA = hQ/2 + h(safety stock)TIC = TOC +TCCROL = (Lead time + safety stock provision) demand
ExampleDemand per annum 360,000 unitsSelling price per unit $12.50Profit margin 20%Fixed cost per order $375Storage costs 3% of average stock valueLead time 5 daysSafety stock provision 3 daysAssume 360 days per annum.
Required:What is the EOQ, TOC, TCC, TIC and ROL if:(a) There is no safety stock?(b) There is safety stock?
QuestionQuestionQuestionQuestion 1111The following financial information relates to Merton Plc, a supplier of photographic equipment and filmservices to the film industry.
Profit and loss accounts for the years ended 30 April are as follows:
2006 2005 2004$m $m $m
Turnover 160.0 145.0 132.0Cost of sales 120.0 105.3 95.7
Capital and ReservesOrdinary shares (50 cents par) 10 10Reserves 50 47
60 57
Note: All sales are on credit. Merton currently pays interest on its overdraft at an annual rate of 4%, althoughthis rate is variable.
Shareholders of Merton Plc have been alarmed by the company’s recent announcement that it intends to cut thetotal dividend for the year. The announcement, which was released on 1 June 2006, also said that Merton Plc isconsidering expanding into the retail camera market, as a result of which it expects future share price growthand dividend growth to be at least 8% per year. Following the announcement, the company’s share price fellfrom $2.70 to $2.45 (on an ex dividend basis) where it has remained.
The Board of Merton Plc has not announced how it plans to finance the proposed expansion into the retailcamera market, but it believes that the additional capital needed would be at least $19 million. It also believesthat the expansion will generate an after-tax return of 9% per year. The newly-appointed Finance Director hassuggested a rights issue to finance the proposed expansion, but he is concerned that the recent fall in thecompany’s share price may cause many shareholders to decide against taking up their rights. Merton Plc has notissued any new shares for the last three years.
The Finance Director believes that a rights issue would be a 1 for 2 rights issue at a 20% discount to the currentshare price. The rights issue would be underwritten by the issuing house for a fee of $300,000.
The Finance Director decided when taking up his appointment that substantial improvement was needed in thearea of working capital management and asked the factoring subsidiary of a major bank to provide a quotationfor non-recourse factoring. The factor has indicated that it would require an annual fee of 0.5% of sales. Itwould advance Merton Plc 80% of the face value of sales at an interest rate 1% above the current overdraft rate.It expects the average time taken by debtors to pay to fall immediately to 75 days, with a reduction to no morethan the average for the sector within two years.
The Finance Director has also been assured that bad debts, currently standing at $500,000 per year, would fallby 80%. Savings in current administration costs of Merton Plc of $100,000 per year would be achieved as aresult of factoring.
The Finance Director has collected the following average data for the media sector:
Return on capital employed 12% Stock days 100 daysGross profit margin 25% Debtor days 60 daysNet profit margin 8% Creditor days 50 daysInterest cover 8 times Current ratio 3.5 timesGearing (Debt / Equity using book values) 50% Quick ratio 2.5 times
QuestionQuestionQuestionQuestion 2222Extracts from the recent financial statements of Anjo Plc are as follows:
Profit and Loss account,
2006 2005$000 $000
Turnover 15600 11100Cost of sales 9300 6600Gross profi t 6300 4500Administration expenses 1000 750Profi t before interest and tax 5300 3750Interest 100 15Profi t before tax 5200 3735
3870 1750Total assets less current liabilit ies 8800 7700
20052006
All sales were on credit. Anjo Plc has no long-term debt. Credit purchases in each year were 95% of cost ofsales. Anjo Plc pays interest on its overdraft at an annual rate of 8%. Current sector averages are as follows:Stock days 90 days
Standard is a predetermined measureable quantity set in defined conditions
Standard cost is a standard expressed in money. It is built up from an assessment of the value of cost elements.Its main uses are for providing bases for performance measurement, control by exception reporting, valuingstocks and establishing selling prices.
Attainable standard is a standard which can be attained if a standard unit of work is carried out efficiently, amachine properly operated or a material properly used. Allowances are made for normal losses, waste andmachine downtime.
Ideal standard is a standard which can be attained under the most favourable conditions, with no allowances fornormal losses, waste and machine downtime. Also, it is known as potential standard.
Variance is the difference between planned, budgeted or standard costs and actual costs (similar for revenue).
Variance accounting is a method by which planned activities are compared with actual results to provideinformation for variance analysis.
Variance analysis is the analysis of performance by means of variances that is used to promote managementaction at the earliest possible stages.
UsesUsesUsesUses ofofofof standardstandardstandardstandard costscostscostscostsPlanningAs standards are pre-determined and plans relate to future periods of time, standards are used for the preparationof budgets.
ControlStandards are compared with actual results and variances calculated are analysed to provide information forcontrol.
Decision makingDecisions relate to future periods of time and will affect future outcomes. Standards are designed to reflect thefuture and are most suitable for decision making.
Performance evaluationThe performance of managers may be measured according to their ability to achieve the standards set. Ratiosmay be calculated to measure efficiency.
Financial accountingStandard costs are often used as the basis for stock valuations for inclusion in financial accounts.
PrinciplesPrinciplesPrinciplesPrinciples appliedappliedappliedapplied inininin variancevariancevariancevariance calculationscalculationscalculationscalculations���� Variance analysis, in general, is fundamentally concerned with taking differences between actual results
achieved and yardsticks, as represented by standards or budgets.
���� Standard costing variance analysis is primarily concerned with asking “what costs should be” for the actuallevel of output (and not for the budgeted level of output)
���� Variances can relate to either quantities or values.
���� Quantity type variances are always valued at standard values, and price type variances are always based onactual quantities.
���� Variances must be interpreted, so that management can take appropriate action. Interpretation concernsdeciding the significance of variances and corrective action will be taken if significant.
���� Significance depends on size (absolute terms), size (relative terms), favourable / adverse, operational /planning, and interdependence.
StandardStandardStandardStandard costingcostingcostingcosting ---- objectivesobjectivesobjectivesobjectives� To provide a formal basis for assessing performance and efficiency.
� To control costs by establishing standards and analysing variances.
� To enable the principle of “management by exception” to be practised at the detailed operational level.
� To assist in setting budgets.
� The standard costs are readily available substitutes for actual average unit costs, and can be used for stockand work-in-progress valuations, profit planning and decision-making, and as a basis for pricing where“cost-plus” systems are used.
� To assist in assigning responsibility for non-standard performances in order to correct defiencies or tocapitalize on benefits.
� To motivate staff and management.
� To provide a basis for estimating.
� To provide guidance on possible ways of improving performance.
StandardStandardStandardStandard costingcostingcostingcosting ––––advantagesadvantagesadvantagesadvantages1. Standard costing is an example of management by exception. By studying the variances, management’s
attention is directed towards those items which are not proceeding according to plan. Management are ableto delegate cost control through the standard costing system knowing that variances will be reported.
2. The process of setting, revising and monitoring standards encourages reappraisal of methods, materials andtechniques so leading to cost reductions.
3. Standard costs represent what the parts and products should cost. They are not merely averages of pastperformances and consequently they are a better guide to pricing than historical costs. In addition, theyprovide a simpler basis of inventory valuation.
4. A properly developed standard costing system with full participation and involvement creates a positive, costeffective attitude through all levels of management right down to the production floor and thereby increasesmotivation and goal congruence.
StandardStandardStandardStandard costingcostingcostingcosting –––– disadvantagesdisadvantagesdisadvantagesdisadvantages1. It may be time consuming and expensive to install and to keep up to date.
2. In volatile conditions, with rapidly changing methods, rates and prices, standards quickly become out of dateand thus lose their control and motivational effects. This can cause resentment and loss of internal goodwill.This problem may be overcome by using planning and operational variances but will mean moresubjectively and also more work.
3. Elaborate variances may be imperfectly understood by line managers and are unlikely to be effective forcontrol purposes.
4. Virtually all aspects of standard setting involve forecasting and subjective judgements, with inherentpossibilities of error and argument.
5. All forms of variance analysis are post-mortem of past events. As the past cannot be altered the only valuevariances can have, is to guide management, if identical or similar circumstances occur in the future. Thisimplies stable, repeating situations which is not always a reflection of reality.
MaterialMaterialMaterialMaterial variancesvariancesvariancesvariances(a) Material cost variance
AMC SMC for AO(AQ x AP) (SQ for AO x SP)
(b) Material price variance(AP SP) AQ consumedAMC (AQ x SP)
(c) Material usage variance(AQ SQ for AO) SP
(d) Material mixture variance(AQ in AM AQ in SM) SP
(e) Material yield variance(AY SY from AI) S Cost/unit Output
LabourLabourLabourLabour variancesvariancesvariancesvariances(a) Labour cost variance
ALC SLC for AO(AH x AR) (SH for AO x SR)
(b) Labour rate variance(AR SR) AH paidALC (AH paid x SR)
(c) Labour efficiency variance(AH worked SH for AO) SR
(d) Idle time variance(IT x SR)(AH paid AH worked) SR
FixedFixedFixedFixed overheadoverheadoverheadoverhead variancesvariancesvariancesvariances(a) Total fixed overhead variance
AF O/H incurred SF O/H for AOAF O/H incurred (SH for AO x FOAR)
(b) Fixed overhead expenditure varianceAF O/H incurred Budgeted F O/H
(c) Fixed overhead volume variance(SH for AO Budgeted H) FOAR(Actual Output Budgeted Output) FOAR/unit
(d) Fixed overhead capacity variance(AH worked Budgeted H) FOAR
(e) Fixed overhead efficiency variance(AH worked SH for AO) FOAR
VariableVariableVariableVariable overheadoverheadoverheadoverhead variancesvariancesvariancesvariances(a) Total variable O/H variance
A VO/H incurred S VO/H for AOA VO/H incurred (SH for AO x VOAR)
(b) V O/H expenditure varianceA VO/H incurred A VO/H absorbedA VO/H incurred (AH worked x VOAR)
(c) V O/H efficiency variance(AH worked SH for AO) VOAR
SalesSalesSalesSales (margin)(margin)(margin)(margin) variancevariancevariancevariance(a) Total sales (M) variance
Actual Quantity Sold Budgeted Quantityx x
Actual SP – Std cost [A profit/unit] Standard SP – Std cost [S profit/unit])
(b) Selling price variance(ASP SSP) AQ SoldA Sales (AQ Sold x SSP)
(c) Sales (M) volume variance(AQ Sold Budgeted Q) S Profit/unit
(d) Sales mixture variance(AQ in AMix AQ in SMix) S Profit/unit
(e) Sales quantity variance(AQ in SMix Budgeted Q in SMix) S Profit/unit
1. (a) Define the terms “Direct material price variances” and “Direct material usage variances”(b) Illustrate your definitions in (a) above by calculating each variance, using the following information:-
Actual cost of materials used $2400Production (units) 295Actual usage 1920 kgStandard cost per kilogram $1.05Standard material quantity per unit of production 8 kg
2. The standard composition of a team of workers is as follow:-
Number of workers Grades of labour Standard hourly rate of pay10 skilled 85 cents6 semi-skilled 70 cents
12 unskilled 60 cents
There is a guaranteed 40 hour week and the standard output for the week is 200 components. During theweek to be analysed the team was made up as follows:
Number Grades Actual wages paid10 Skilled $348.006 Semi-skilled $168.00
12 Unskilled $302.40
The number of components produced during the week was 215 despite a mechanical breakdown whichlasted 2 hours and a delay in the delivery of materials causing a further hold up of one hour. Calculate thelabour variances and present them in a suitable form to the production manager.
3. Favad Ltd makes a single product and operates a system of variance accounting. In Department X, thestandard hourly rate for direct workers is set at $4.50 per hour and each unit of product requires 6 standardhours in the department. Fixed overhead in the department is budgeted to cost $165,000 per month at a
normal monthly level of production of 5,000 units of product. There is no opening or closing work-in-progress.
During last month, 4650 units of product were made, direct workers worked 26800 hours, costing $124,350and fixed overhead incurred in the department was $158,650.
4. A company controls its manufacturing operations by a system of standard costing. Extracts from the originalbudgets and variance statements for a nationally distributed product show:
BudgetsPlanned production 500,000 units of productPlanned hours 10,000Material 50,000kg $50,000Labour 10,000 hours x $6 $60,000
Variance statementsActual production 45,000 units of productMaterial Price Variance $7,125 (F)Material Usage Variance $2,500 (A)Labour Rate Variance $2,625 (A)Labour Efficiency Variance $1,500 (F)
5. KC Chemicals Limited produce an industrial purifying agent known as Kleenchem, the budgeted weeklyoutput/sales of which is 10,000 litres, the standard cost per 100 litres being:
Material 250 kg costing 50 cents per kgLabour 4 hours at $1.25 per hourOverhead $5 (budgeted absorption of fixed cost)
The standard selling price is $1.50 per one-litre container.
During the week ended 26 November the output of Kleenchem was 9,860 litres all of which were sold, theinvoiced value being $14,750. The material input was 24,720 kg which cost $12,300. Production employeesbooked 380 hours to the process and were paid $490. Overhead amounted to $525.
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