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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, overheads in SCC must be reapportioned until all overheads are in the PCC.

Overheads allocation & apportionment 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. 2. 3. 4. 5. Machine hour / Direct labor hour Area (Space) Number of employees Value of plant, machinery, stock Wages

Bases used for re-apportionment of overheads Basis of apportionment in order of preference DA / Sales (value) Value of building / Area DA / No. of employees DA / Area DA / Output (units) Value of building / Area Value of machinery / Machine hours Direct wages DA / Volume / Area Output (value) / Output (units) / No. of employees DA / Output (units) Output (value) / Direct labor hours DA / Area Value of machinery Machine hours / Direct labor hours No. of issues / Value of material issued Overtime pay / Overtime hours / Direct labor hours DA / KWHr / Horsepower No. of production runs Area DA / Machine hours / Direct labor hours Production hours / No. of employees Value of material No. of employees DA / Sales (value) / Sales (units) DA / Direct wages / No. of employees

Item Advertising Building Insurance Canteen Cleaning Consumable materials Depreciation of building Depreciation of machinery Direct wages related costs Heat or Air-conditioning

Factory Admin & Supervision Indirect material Indirect wages / labor Lighting Machine insurance Maintenance Material handling costs

Overtime premium Power Production scheduling & expediting Rent and rates Repairs Salaries Stock / material insurance Time-keeping Transport Welfare Services

Bark removal Direct wages Number of employees Floor area (m2) Number of machine set-ups Plant and machinery operating hours RM160000 14 2500 15 1400 Sawing RM90000 8 5000 25 4200 Cleaning RM30000 3 nil nil 700 Canteen RM20000 2 500 nil 700 Budgeted overhead costs for the next year are: RM'000 Direct wage related costs Supervisory salaries: bark removal sawing cleaning canteen Maintenance wages Lighting and heating Power Production scheduling 200 30 36 14 12 40 54 88 26 Required: Prepare an overhead analysis sheet showing the allocation and apportionment of overhead costs to cost centres. . Budgeted information for next year is given below.Example 1: LGF Ltd operates a timber sawmill.

on the other hand. This refers to a situation where a SCC provides services to another SCC and vice versa. namely as follows:(a) Reapportionment with interservice (b) Reapportionment without interservice * Interservice is also called Reciprocal Service.Overhead re-apportionment A business may have more than one type of cost centre. are not directly involved with the cost unit but exists to provide services to other cost centres. A service cost centre. thereby. A production cost centre is one which is directly involved with the creation of the cost unit. as only they are in contact with the cost units. enabling absorption to the cost units. These methods are:(a) (b) (c) (d) Ignore interservice Elimination method Repeated distribution Simultaneous equation . Overheads from Service Cost Centres may be reapportioned to Product Cost Centres using one of four methods below:(a) (b) (c) (d) Ignore interservice Elimination method Repeated distribution Simultaneous equations Reapportionment is divided into 2 types. There are four (4) methods that can be adopted in order to compute the overheads after apportionment. Reapportionment will always depend upon the extend of services provided. Overheads allocated or apportioned to service cost centres must be re-apportioned to production cost centres.

are as follows: RM ‘000 G H 160 82 The use made of each of the services has been estimated as follows: Production department 1 G (%) H (%) 60 50 2 30 30 Service department G 20 H 10 - Required: Apportion the service department costs to production departments using the following methods: (a) (b) (c) (d) Ignore interservice Elimination method Repeated distribution Simultaneous equation .Example 2: JR Company Limited’s budgeted overheads for the forthcoming period applicable to the production departments are as follows: RM ‘000 1 2 870 690 The budgeted total costs for the forthcoming period for the service departments.

to be applied to the actual base. Absorption of overhead costs is required for:(a) (b) (c) (d) valuation of work-in-progress valuation of finished goods profit measurement decision making In order to absorb overheads into cost units. Budgeted direct labor hours were 13100 for filling and 10250 for sealing. are established for the two production departments. based on direct labor hours. It is the charging of accumulated costs to cost units. Predetermined overhead absorption rates. in the factory. There are two departments. For each basis a predetermined absorption rate will be calculated. This is sometimes referred to as overhead recovery. 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) (ii) (iii) (iv) (v) Direct labor hours Machine hours Direct material cost Direct labor cost Prime cost Over / under absorbed The use of a predetermined absorption rate will give rise to over / under absorbed overhead since the actual overhead 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. an absorption base will be used. The budgeted expenditure for these departments for the period just ended. and £53300 for sealing. maintenance and canteen. . was £110040 for filling. These two departments are concerned with filling and sealing operations. including the apportionment of service department overheads.Overhead Absorption Rates Overhead is absorbed in the cost units produced in each cost centre.

e. 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 cost attributable 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. Therefore. and total overheads are absorbed according to activity level” Marginal costing Marginal costing is a costing approach which is based on the concept that only variable production costs are product cost It is sometimes called direct costing or period costing or variable costing. variable cost of administration and sales) are charged to cost units.Sealing .Maintenance 60% 32% 8% During the period just ended. actual overhead costs and activity were as follows: £ Filling Sealing Maintenance Canteen 74260 38115 25050 24375 Direct labor hours 12820 10075 Required: Calculate the overheads absorbed in the period and the extend of the under / over absorption in each of the production departments. cost of the end product. Cost accumulation means the building up of the cost of something i. cost. variable production overhead. unit of production. . Fixed costs are not absorbed into cost of production instead are treated as period costs and are written off to the profit and loss account (contribution earned) at the period when it is incurred.Sealing . only variable costs (i.Service department overheads are apportioned as follows: Maintenance – Filling . direct labor.Canteen 70% 27% 3% Canteen .Filling . Marginal Costing and Absorption Costing. job or services. For example. direct material.e.

but production fluctuates. � Under or over absorption of overheads is almost entirely avoided. In marginal costing it is necessary to identify: � � � Variable cost Fixed cost Contribution Contribution = Sales price .Variable costs *Contribution may be calculated on a unit basis or in total Contribution provides useful information for decision making. . If selling price and variable cost is constant. Net profit = Contribution – Fixed Cost Advantages � Simple to operate. but written off in full instead. i. Profit per unit changes each time the level of activity changes. � Where sales are constant. Disadvantages The main disadvantage of marginal costing are that closing inventory is not valued in accordance with SSAP 9 principles and that fixed production overheads are not “shared” out between unit production.Marginal costing system values stock and WIP at variable production cost. direct plus variable production overheads. � Fixed overheads are incurred on a time basis. which are frequently on an arbitrary basis of fixed costs to products or departments. Since fixed cost per unit decrease each time an additional unit is made so profit per unit rises with every increase in activity. contribution is the same whatever the activity level. � No apportionments. it is logical to write them off in the period they are incurred and this is done using marginal costing. Therefore.e. marginal costing shows a constant net profit whereas absorption costing shows variable amounts of profit.

process and so on) an appropriate share of the organization’s total overhead. SSAP 9 requires the use of normal level of activity in the calculation of overhead absorption rate. £ Sales Less: Variable cost Opening stock Variable production cost XX XX XX Less: Closing stock (X) XX XX Less: Other variable overheads (sales. absorption costing is a method of product costing which aims to include in the total cost of a product (unit. Fixed production overheads are absorbed into the units through the use of a predetermined absorption rate. In other words. admin) Contribution (X) XX £ XXX Less: Fixed expenses Fixed production cost Fixed selling cost Fixed administration Net profit XX XX XX (XX) XXX Absorption costing Absorption costing approach is based on the concept that all variable as well as fixed production overheads are product cost. It is also known as full costing or conventional costing. the valuation of stock and work-in-progress contain both variable and fixed costs. In absorption costing it is not necessary to distinguish variable and fixed cost in the profit statement. Thus. job.Standard format used under marginal costing. An appropriate share is generally taken to mean an amount which reflects the amount of time and effort that has gone into producing a unit or completing a job. Normal level of activity would mean the expected or budgeted volume of activity (i. . budgeted units or hours).e.

Advantages � � � � � � Value stocks according to the financial accounting principle contained in SSAP 9. Where stock building is a necessary part of operations (seasonal products) the inclusion of fixed costs in stock valuation is necessary and desirable. £ £ Sales Less: Cost of sales Opening stock Production cost Less: Closing stock Over / (under) absorbed overheads Gross profit Less: Expenses Sales / Distribution (VC + FC) Administration Net profit X / (X) XXX XX XX XX (X) XX X / (X) XXX XX XX (XX) XXX Example . 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. Disadvantages � � � It is not effective in helping management control costs. It is not effective in the provision of useful information for decision making. 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 the general overheads. Standard format used under absorption costing. 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. The matching concept requires that all production costs (including fixed production overheads) be matched against revenue. Analyzing under / over absorption of overhead is a useful exercise in controlling costs of an organization.

Normal capacity was 11000 units per month. prepare profit statements for the month of March and April 2010 using:(a) Marginal costing (b) Absorption costing Per unit:Sales price Direct material cost Direct wages Variable production overheads Per month:Fixed production overheads Fixed selling expenses Fixed administrative expenses Variable selling expenses is 10% of sales value.Using the information given below. March (units) Sales Production 10000 12000 April (units) 12000 10000 99000 14000 26000 £50 18 4 3 Tutorial Questions .

2 19050 (h) C 213700 66300 (d) (f) 19520 (6720) Predetermined absorption rate (£ per machine hour) (e) Actual machine utilization (hours) Over / (under) absorption of overhead (£) (g) (3660) Actual overhead incurred in each department was as per budget. B and C respectively. A manufacturing company has three production departments (A. Required: Calculate the missing figures for (a) to (h) in the above table. B and C) and one service department in its factory. The following incomplete information is available concerning the apportionment and absorption of production overhead for a period: Production Department A Budgeted allocated expenses (£) Budgeted service department apportionment (£) Normal machine capacity (hours) 143220 (a) 15000 B 125180 (b) (c) 8. A predetermined overhead absorption rate is established for each of the production departments on the basis of machine hours at normal capacity.Q1. The overheads of each production department comprise directly allocated expenses and a share of the overheads of the service department. All overheads are classified as fixed. apportioned in the ratio 3:2:5 to departments A. (Workings should be shown clearly) Q2 .

Bark removal Direct wages Number of employees Floor area (m2) Number of machine set-ups Plant and machinery operating hours RM160000 14 2500 15 1400 Sawing RM90000 8 2500 15 1400 Cleaning RM30000 3 nil nil 700 Canteen RM20000 2 500 nil 700 Budgeted overhead costs for the next year are: RM'000 Direct wage related costs Supervisory salaries: bark removal sawing cleaning canteen Maintenance wages Lighting and heating Power Production scheduling 200 30 36 14 12 40 54 88 26 Required: Calculate an appropriate overhead absorption rate for each production cost centre.LGF Ltd operates a timber sawmill. Q3 . Budgeted information for next year is given below.

Choyee Ltd intends to commence manufacturing a single product from 1 December. while the remainder is of a fixed nature.00 25. In the first month.00 One third of the factory overheads will vary with units produced.00 5. Budgeted costs per unit based on this level are: £ Prime costs Factory overheads Factory cost Selling / Administration overheads Total cost Add 25% profit Selling price 10. one based on the absorption principle and the other based on the marginal principle. 80% of the selling / administration overheads will be treated as fixed period costs and the remainder will vary with units sold. Q4 . It is expected that the normal level of production and sales will be 12000 units per month.00 20.50 4. the production is budgeted at 12800 units but sales are budgeted to be 11400 units.00 5. Required:Produce 2 separate budgeted Profit & Loss Accounts for December.50 15.

Production Department Fabrication Sales Advertising 30 50 Designing 30 10 Tailoring 20 30 Service Department Sales -10 Advertising 20 -- 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 .Fabric Ltd is a company producing textiles and has three production departments Fabrication. Designing and Tailoring. and two service departments Sales and Advertising. Overheads have been attributed to these departments as follows: £ Fabrication Designing Tailoring Sales Advertising 100000 75000 50000 25000 10000 An analysis of services provided by each service department shows the following percentage of total time spent for the benefit of each department.

(a) (b) (c) Actual overheads cost $170000 and 45000 machine hours were worked. (c) Assuming the total production overhead expenditure of the company in the question above was $176533 and its actual activity was as follows:Machine Shop A 8200 7300 Machine Shop B 6500 18700 Assembly 21900 - Direct labour hours Machine usage hours Using the information above and in part (b).or over. (b) Using the information above and results as per (a). calculate overhead totals for the three production departments. Required: Calculate the under-/over-absorbed overhead. and note the reasons for the under-/over-absorption in the following circumstances. Actual overheads cost $170000 and 40000 machine hours were worked. Cost centre expenses and related information have been budgeted as follows:- Total $ 78560 16900 16700 2400 8600 3400 40200 402000 100 35000 25200 45000 Indirect wages Consumable materials Rent and rates Buildings insurance Power Heat and light Depreciation (machinery) Value of machinery Power usage (%) Direct labour (hours) Machine usage (hours) Area (sq ft) Machine shop A $ 8586 6400 Machine shop B $ 9190 8700 Assembly $ 15674 1200 Canteen $ 29650 600 Maintenance $ 15460 - 201000 55 8000 7200 10000 179000 40 6200 18000 12000 22000 3 20800 15000 6000 2 2000 Required:(a) Using the direct apportionment to production departments method and bases of apportionment which you consider most appropriate from the information provided. Q6. calculate the under. Elsewhere Co has a budgeted production overhead of $180000 and a budgeted activity of 45000 machine hours. Actual overheads cost $180000 and 40000 machine hours were worked.Q5. .absorption of overheads. determine budgeted overhead absorption rates for each of the production departments using appropriate bases of absorption. A company is preparing its production overhead budgets and determining the apportionment of those overheads to products.

purchasing. departmental managers may not feel committed to keeping to these budgets as they have little or no say in their preparation and may be of the opinion that the budgets are unrealistic. but budgets for the following years may be less precise because of uncertainty about future trading conditions. Their preparation ensures the coordination of all the activities of a business. should coordinate the departmental budgets to ensure that they achieve top management’s plans for the business. A budget for one year ahead will be detailed. . in addition to the short-term ones. 2.CHAPTER 2: BUDGETING The difference between a forecast and a budget A business forecast is an estimate of the likely position of a business in the future. The manager of each department or function in a business is responsible for the performance of his or her department or function. as each year passes. 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. Such budgets usually have the merit of being well coordinated so that they all fit together as a logical and consistent plan for the whole business. personnel. The benefits of budgets may be summarized as follows:1. which should include an accountant. Separate operational. based on past or present conditions. opinions differ as to who should prepare these budgets. the year ahead. Bottom-up budgets 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 and consistent overall plan for the business Managers tend to base their own budgets on easily achievable targets to avoid being criticized for failing to meet them. this will result in departments performing below their maximum level of efficiency and be bad for the business as a whole. it is deleted from the budget and a budget for another year is added. However. say. they are committed to meeting them. However. a budget is a statement of planned future results which are expected to follow from actions taken by management to change the present circumstances. or functional. production. but larger businesses need to plan further ahead and prepare long-term budgets. 3. and budgets are essential tools for planning and controlling. Well-managed businesses have short-term budgets for. A budget committee. Budgets as tools for planning and control Planning Managers are responsible for planning and controlling a business for the benefit of its owners. etc. treasury (cash and banking). administration. who are responsible for putting them into effect. budgets must be prepared for each department or activity detailing the department’s revenue (if any) and expenses for a given period. They are formal statements in quantitative and financial terms of management plans. These plans are often known as rolling budgets because. The budgets will be prepared for sales. When managers are involved in the preparation of their budgets. ten or even more years ahead. 4. Small businesses may function well enough with these. for the next five. Top-down budgets are prepared by top management and handed down to departmental managers.

and departmental management accounts are prepared for those periods. Managers should concentrate their attention on items with adverse variances and. if ‘actual’ is worse than budget. the production budget will be prepared first and the sales budget will then be based on the production budget. Preparation of a Sales Budget Sales budget are based on the budgeted volume of sales. May 1500.Control Control involves measuring actual performance. It is important that deviations from budget are discovered early before serious situations arise. . March 1100. If actual revenue and expenditure are better than budget. The current price per unit is $15 but the company plans to increase the price by 5% on 1 May. Limiting (or principal budget) factors Limiting factors. the variance is described as adverse. April 1300. a sales budget is prepared first. If the limiting factor is the availability of materials or labor. Required:Prepare a sales budget. If the limiting factor is one of demand for the product. which limits production Shortage of labor. February 800. The other budgets will then be prepared to fit in with the sales budget. Example Xsel Ltd’s sales for the six months from January to June 2010 are budgeted in units as follows:January 1000. Departmental management accounts usually contain many items of revenue and expenditure with a mixture of favorable and adverse variances. June 1400. Examples are:• • • Limited demand for a product Shortage of materials. This is known as management by exception or exception reporting. management accounts may report only the items with adverse variances. Annual departmental budgets are broken down into four-weekly or monthly. On the other hand. The volume is then multiplied by the selling price per unit of production to produce the sales revenue. are circumstances which restrict the activities of a business. the differences (or variances) are described as favorable because they increase profit. periods. sometimes called principal budget factors. These management accounts compare actual performance with budget and must be prepared promptly after the end of each period if they are to be useful. or even weekly. which also limits production Limiting factors must be identified in order to decide the order in which the departmental budgets are prepared. comparing it with the budget and taking corrective action to bring actual performance into line with the budget. to help managers focus their attention on these.

Preparation of a Purchases Budget A purchases budget may be prepared for either:1. Budgeted sales for July 2010 are for 1800 units. The purchases budget is calculated as follows:- Units produced per production budget x quantity of material per unit produced x price per unit of material *Note – ensure that the purchases are made in the correct month Example Xsel Ltd purchases its raw materials one month before production. or. . Each unit of production requires 3 kg of material. raw materials purchased by a manufacturer.Preparation of a Production Budget Manufacturing companies require production budgets to show the volume of production required monthly to meet the demand for sales. 2. Required:Prepare Xsel Ltd’s monthly production budget for the period from December 2009 to June Ltd’ 2010. goods purchased by a trader A manufacturing company’s purchases budget is prepared from the production budget while a trader’s purchases budget is prepared from a sales budget. Required:Prepare the purchases budget for the materials to be used in the production of goods for the period from December 2009 to June 2010. Monthly production is 105% of the following month’s sales to provide goods for stock and for free samples to be given away to promote sales. It is important to check that production is allocated to the correct months. Example Xsel Ltd manufactures its goods one month before they are sold. which costs $2 per kg.

April $7000. Receipts from credit customers who are allowed cash discounts must be shown at the amounts after deduction of the discounts. All amounts should be shown to the nearest $. Special care must be taken with respect to the following:• Sales revenue must be allocated to the correct months. The discounts should not be shown separately as an expense. February $7100. May $7300.Preparation of an Expenditure Budget An expenditure budget includes payments for purchased materials (from the purchases budget) plus all other expenditure in the period covered by the budget. Required:Prepare an expenditure budget for Xsel Ltd for the six months ending 30 June 2010. Preparation of a Cash Budget Cash budgets are prepared from the sales and expenses budgets. 30 June. Monthly wages of $4000 are paid in the month in which they are due. 2. 30 September and 31 December. General expenses are paid in the month in which they are incurred and are to be budgeted as follows: January $6600. • . The commission is paid in the month following that in which it is earned. read the question carefully. The staff are paid a commission of 5% on all monthly sales exceeding $15000. June $7500 4. Xsel Ltd pays interest of 8% on a loan of $20000 in four annual installments on 31 March. Its other expenses are as follows:1. Payments to suppliers (purchases) must be shown in the correct months. 5. 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. 3. A final dividend of $2000 for the year ended 31 December 2009 is payable in March 2010. March $6900.

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 and receive 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 31 December 2009 was $12400. Required:Prepare Xsel Ltd’s cash budget for the six months ending 30 June 2010. All amounts should Ltd’ be shown to the nearest $.

Preparation of a Master Budget 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 management the profit or loss to be expected if management’s plans for the business are implemented, and the state 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 is advisable to identify these when preparing the cash budget. Much information additional to that required for the functional budgets mentioned above will usually be given. Details of fixed assets which are to be sold or purchased will often be supplied; this information will usually be included in a capital budget.

Example Meadowlands Ltd’s Balance Sheet at 31 December 2009 was as follows: Cost $ Fixed assets Equipment Motor vehicles 13000 11000 24000 6000 7000 13000 7000 4000 11000 Depreciation $ Net $

Current assets Stock Trade debtors Cash at bank 9600 33600 15000 58200

Current liabilities Trade creditors 6200 52000 63000

Share capital and reserves Ordinary shares of $1 Profit and loss account 40000 23000 63000

Further information: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 as follows: Purchases Sales $ January – March April – June July – September October – December 72000 96000 84000 96000 $ 132000 156000 168000 144000

3. Meadowlands Ltd receives one month’s credit on all purchases and allows one month’s credit on 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 October b) wages of $7200 payable each month c) an insurance premium of $3000 for 15 months to 31 March 2011 paid on 1 January 2010 d) 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 December 2009 will be sold for $2000 on 1 July 2010. 8. The company depreciates equipment at 10% per annum on cost. It depreciates motor vehicles at 12.5% per annum on cost. 9. The company’s stock at 31 December 2010 will be valued at $32000.

Required:(a) Prepare a cash budget for the year ending 31 December 2010 (b) Prepare Meadowlands Ltd’s budgeted Profit and Loss Account for the eyar ending 31 Ltd’ December 2010 and a budgeted Balance Sheet as at that date.

The accountant is provided with the following data: Greenfields Ltd Balance Sheet as at 31 December 2009 Cost $ Fixed assets Freehold premises Plant and machinery 50000 37500 87500 10000 22500 32500 40000 15000 55000 Depreciation $ Net $ Current assets Stock Trade debtors Balance at bank 30000 42500 20750 93250 Current liabilities Trade creditors 22500 70750 125750 Long-term liability 12% debentures 2012/2013 25000 100750 Share capital and reserves Ordinary shares of $1 General reserve Retained profit 65000 30000 5750 100750 . they require the accountant to prepare master budgets.Tutorial Question The directors of Greenfields Ltd have prepared functional budgets for the four months ending 30 April 2010. To discover the effect that the budgets will have on the company at the end of the four months.

6. . and the balance to administration expenses. 7. Sales and purchases for the four months from January to April 2010 are busgeted to be:Sales Purchases $ January February March April 62500 70000 75000 82500 $ 25000 20000 30000 37500 2. Additional plant and machinery costing $60000 will be purchased on 1 March 2010. 3. The company pays for its purchases in the month following purchase. Stock at the 30 April 2010 is estimated to be valued at $22500. Plant and Machinery 20%. 10. Required:a) Prepare a cash budget for each of the four months from January 2010 to 30 April 2010. Debenture interest is payable half-yearly on 30 June and 31 December. A dividend of $0.Further information:1.10 per share will be paid on the ordinary shares on 30 April 2010. Administration expenses amount to $20000 per month and are paid in the month in which they are incurred. Annual depreciation of fixed assets is based on cost as follows: Freehold premises 3%. one month’s credit is allowed on the remainder. 40% of sales are to cash customers. 9. $25000 will be transferred to the General Reserve on 30 April 2010. 5. 50% of all depreciation is to be charged to selling and distribution expenses. b) Prepare a budgeted Profit and Loss Account for the four months ending 30 April 2010 in as much detail as possible. c) Prepare a budgeted Balance Sheet as at 30 April 2010 in as much detail as possible. 8. 4. Selling and distribution expenses amount to 10% of sales and are paid in the month in which they are incurred. 11.

5. one-sixth). in a product launch situation. This can be proved by tossing the coin many times and observing the results. be very pleased with such a low return. at a higher price or no similar product being launched. the probability of not passing the examination is 0. For example. It is unlikely that objective probabilities can be established for business decisions.0. there is not a variety of possible future eventualities – only one will occur. Risk and uncertainty – The terms risk and uncertainty can be used interchangeably as risk refers to the occurrence of an uncertain event. such as revolution.7 then this means that the student has 70% chance of passing the examination. for instance. past experience. For example. This again can be ascertained from logical reasoning or recording the results obtained from repeated throws of the dice. Uncertainty applies in cases when it is not possible to assign probabilities (or even identify all the possible outcomes). it is necessary to consider those uncontrollable factors that are outside the decision maker’s control and that may occur for alternative courses of action. Risk describes a situation where there is not just one possible outcome. Such situations are rare. Usually. A value of 0 denotes a nil likelihood of occurrence whereas a value of 1 denotes absolute certainty – a definite occurrence. Probabilities established in this way are known as subjective probabilities because no two individuals will necessarily assign the same probabilities to a particular outcome. Strictly speaking. the probability of obtaining number 1 when a die is thrown is 0. and observations of current . lending to a reputable government by purchasing three-month treasury bills. possible states of nature could consist of events such as a similar product being launched by a competitor at a lower price. Given that the pass/fail alternatives represent an exhaustive listing of all possible outcomes of the event. at the same price. The range and distribution of these possible outcomes may be estimated on the basis of either objective probabilities or subjective probabilities (or a combination of two). The likelihood that an event or state of nature will occur is known as its probability.7 0. For example.3. Shareholders may not. the probability of heads occurring when tossing a coin logically must be 0. 5% per year. A probability distribution is a list of all possible outcomes for an event and the probability that each will occur. the best that can be done is to make an estimate of the range of the possible future inflows and outflows. but an array of potential returns. however. Management rarely have precise forecasts regarding the future return to be earned from an investment. Similarly. The total of the probabilities for events that can possibly occur must sum to 1. That is. and this is normally expressed in decimal form with a value between 0 and 1. Thus a firm could undertake a project that had almost complete certainty by investing its funds in treasury bills. This information can be presented in a probability distribution. if a tutor indicates that a probability of a student passing an examination is 0. since many past observations or repeated experiments for particular decisions are not possible. A probability of 0. RETURN Introduction Businesses operate in an environment of uncertainty. Probabilities Because decision problems exist in an uncertain environment.3 1.166 (i. Tossing a coin and throwing a die are examples of objective probabilities. war or major earthquake.e.4 means that the event is expected to occur 4 times out of 10.CHAPTER 3: RISK. risk occurs when specific probabilities can be estimated for the possible outcomes.0 Some probabilities are known as objective probabilities because they can be established mathematically or compiled from historical data. the probabilities will have to be estimated based on managerial judgement. then you can be certain of receiving your original capital plus interest. but there are some investments which are a reasonable approximation to certainty. The probability distribution for the above illustration is as follows: Outcome Pass examination Do not pass examination Probability 0. Unless you are very pessimistic and expect catastrophic change over the next three months. and receiving a return of. These uncontrollable factors are called events or states of nature. say. Subjective probabilities are based on an individual’s expert knowledge. Certainty – Under expectations of certainty future outcomes can be expected to have only one value. There are two types of expectations individuals may have about the future: certainty and uncertainty.

for example. the pay-off) from each alternative course of action but also the amount of uncertainty that applies to each alternative.e. A detailed investigation of the possible sales demand for each product gives the following probability distribution of the profits for each product.1 0. The advantage of this approach is that it provides more meaningful information than stating the most likely outcome.6 0. a situation where a tutor is asked to state whether student A and student B will pass an examination. This is the tutor’s estimate of the most likely outcome. Probability distributions and expected value The presentation of a probability distribution for each alternative course of action can provide useful additional information to management. because it indicates that it is most unlikely that A will fail. Probability distributions enable management to consider not only the possible profits (i.2 1.0 Outcome Profits of $4000 Profits of $6000 Profits of $8000 Profits of $10 000 Profits of $12 000 Product B probability distribution Estimated probability Weighted 0.1 0. This information is clearly more meaningful than a mere estimate of the most likely outcome that both students are expected to pass the examination.4 1.4 0. but any estimate of a future uncertain event is bound to be subject to error. but only one can be produced. possible outcomes) by its associated probability.0 Student A Probability 0.4 0. since the distribution indicates the degree of uncertainty that exists for each alternative course of action. The sum of these weighted amounts is called the expected value of the probability distribution.2 0. whereas there is a possibility that B will fail. Let us now apply the principles of probability theory to business decision-making. Example 1 A manager is considering whether to make product A or product B.2 0. Consider.0 Outcome Which product should the company make? Expected values The expected value (sometimes called as expected pay-off) is calculated by weighting each of the profit levels (i.25 0. the expected value is the weighted arithmetic mean of the .0 Student B probability Such probability distribution requires the tutor to specify the degree of confidence in his or her estimate of the likely outcome of a future event.05 0.1 1. the following probability distribution is preferable: Outcome Pass examination Do not pass examination 0. Profits of $6000 Profits of $7000 Profits of $8000 Profits of $9000 Profits of $10 000 Product A probability distribution Estimated probability Weighted 0. Such probabilities are unlikely to be estimated correctly.9 0.variables which are likely to have an impact on future events.e. The estimated sales demand for each product is uncertain. In other words. The tutor may reply that both students are expected to pass the examination.1 1. However.

because of the greater variability of the possible outcomes. However. management is also interested in the degree of uncertainty of the expected future profits. The conventional measure of the dispersion of a probability distribution is the standard deviation. There is no guarantee that the actual outcome will equal the expected value. the expected value calculation takes into account the possibility that a range of different profits are possible and weights these profits by the probability of their occurrence. The expected values are the averages of the possible outcomes based on management estimates. Measuring the amount of uncertainty In addition to the expected values of the profits for the various alternatives. is the expected or mean value.5 0. The expected values of $8000 and $8900 calculated for products A and B take into account a range of possible outcomes rather than using a single most likely estimate. say. there is a greater degree of uncertainty attached to product C. say. where n is the total number of possibilities. In other words. the expected value for product B does not appear in the probability distribution. For both products A and B in the above example the single most likely estimate is $8000. let us assume that another alternative action. P is the probability of each outcome. and the summation is over all possible observations. which appears to indicate that we may be indifferent as to which product should be made. The weighted 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 a particular course of action is undertaken many times. if the decision to make products A and B is repeated on.5 Weighted amount Product C has a higher expected value than either product A or product B. the single most likely estimate is the profit level with the highest probability attached to it. Indeed. For example. product C. 100 occasions in the future then product A will be expected to give an average profit of $8000 whereas product B would be expected to give an average profit of $8900. The standard deviation is the square root of the mean of the squared deviations from the expected value and is calculated from the following formula: σ = n ∑ (A )P where A are the profit-level observations. For example.possible outcomes. Calculation of standard deviations for products A and B (based on the above example) Product A StandardProbability deviation Profit ($) Deviation from expected value Weighted amount . is added to the alternatives in the example above and the probability distribution is as follows: Outcome Loss of $4000 Profit of $22000 Product C probability distribution Estimated probability 0. For example. but it is unlikely that management will prefer product C to product B.

sales and costs). since they do not provide the decision-maker with all the relevant information. Decision tree analysis In practice.241 (21424/89000). say product D.1%). Each alternative course of action or event is represented by a branch.Profit ($) Deviation from expected value Product B StandardProbability deviation Weighted amount If we are comparing the standard deviations of two probability distributions with different expected values.25 0.2 1. This scale effect can be removed by replacing the standard deviation with a relative measure of dispersion. Let us now consider Example 2. and for product D it is also 0.241 (or 24.05 0. The value of a decision tree is that its logical analysis of a problem enables a complete strategy to be drawn up to cover all eventualities before a firm becomes committed to a scheme. Decision trees are designed to illustrate the full range of alternatives and events that can occur. In such situations management may have no alternative but to compare the expected values and coefficients of variations. The coefficient of variation for product B is 2142. Such an approach is appropriate when management must select one from a small number of alternatives.4 0. the standard deviation for product D is ten times as large as that for product B.0 Outcome Profits of $40000 Profits of $60000 Profits of $80000 Profits of $100000 Profits of $120000 The standard deviation for product D is $21424. under all envisaged conditions. Many outcomes may therefore be possible. we cannot make a direct comparison.e.1 0. Nevertheless. . The outcomes for product D also have the same pattern of probabilities as product B. but they are poor substitutes for representing the probability distributions. standard deviations or coefficient of variations are used to summarize the characteristics of alternative courses of action. but in situations where many alternatives need to be considered the examination of many probability distributions is likely to be difficult and time-consuming. The relative amount of dispersion can be expressed by the coefficient of variation. and also the value of some variables may be dependent on the values of other variables.g. Product D probability distribution Estimated probability Weighted amount ($) 0. and we might conclude that the two projects are equally risky. more than one variable may be uncertain (e. and some outcomes may be dependent on previous outcomes. but all of the possible outcomes are ten times as large as the corresponding outcomes for product B. Let’s consider the following probability distribution for another product. Measures such as expected values. thus indicating that the relative amount of dispersion is the same for both products. A useful analytical tool for clarifying the range of alternative courses of action and their possible outcomes is a decision tree.40/8900 = 0. states of nature) and the potential outcomes for each course of action. which leads to subsidiary branches for further courses of action or possible events. This will be used to illustrate how decision trees can be applied to decision-making under conditions of uncertainty. A decision tree is a diagram showing several possible courses of action and possible events (i. There is an argument for presenting the entire probability distribution directly to the decision-maker. which is simply the standard deviation divided by the expected value.

If large premises are built then the probability of high demand is 0. then net income is expected to be $600000. If the smaller premises are built then the probability of high demand falls to 0. Small premises would cost $300000 to build and large premises would cost $550000.25 probability that the development effort will be marketed. Alternatively. and there is a 0.6. if low demand exists. Regardless of the type of premises built.75 probability that the development effort will be successful and a 0. there will be a loss of $400000 Each of the above profit and loss calculations is after taking into account the development costs of $180000.4 0. The estimated probabilities of each of the above events are as follows: 1. 3.3 Tutorial Question Firlands Ltd. Development costs are estimated to be $180000. is faced with a decision regarding whether or not to expand and build small or large premises at a prime location. and it is estimated that: 1. if high demand exists then the net income is expected to be $1500000.Example 2 A company is considering whether to develop and market a new product. . If the product is very successful profits will be $540000 If the product is moderately successful profits will be $100000 If the product is a failure.. a retail outlet.75. 3. Very successful Moderately successful Failure 0. 2. 2.3 0.

we invest in both fixed assets and current assets.Firlands has the option of undertaking a survey costing $50000. three steps are involved: (1) Estimation of cash flows (2) Analysis (3) Decision making Estimation of cash flows – using cash budgets Only relevant cash flows arising or associated with the investment should be included. The likelihood of there being a good response. establish the best course of action for Firlands Ltd. The survey predicts whether there is likely to be a good or bad response to the size of the premises. Whereas investments in current assets are short term investments and are to be evaluated using working capital management tools. If the survey indicates a good response then the company will build the large premises. Schedule of net cash flows Time T0 T1 T2 T3 T4 Cash inflows . If the survey indicates a bad response then the company will abandon all expansion plans.8. CHAPTER 4: INVESTMENT APPRAISAL (Capital investment decisions) As a business. duly adjusted for the effects of taxation and inflation if appropriate. Investment in fixed assets represents investment in long term investments and to be evaluated using the capital budgeting techniques. Required: Using decision tree analysis. In Capital Budgeting.95. has been estimated at 0. If the survey does give a good result then the probability that there will be high demand from the large premises increases to 0. from previous surveys.

2. Analysis: Analysis are in four main areas: . Since all projects involve cash inflows and outflows with different sizes and timing. the greater the risk and higher return will be required by investors. They must be considered to ensure that there is always sufficient cash in the company to meet the daily payments and dividends. 4.What is the rate of return on investment? . received and repayment etc. Payback period analysis Payback period analysis is concerned about how fast the money invested can be recovered by the cash flows generated by the project.How much profit can we make? . causing the cost of capital to rise in the long term or share price to fall. Its purpose is to avoid the company from accepting high risk projects. Financing cash flows – include interests. the management must consider its implications like: a) The effect on the liquidity of the company. Tax cash flows – include tax payable and tax saved Tax payable – calculated based on operating cash flows Tax saved – based on capital allowance on qualifying capital expenditure Investment cash flows Investment and disposal of fixed assets Investment and recovery of working capital After-tax cash flows – treated like investment cash flows otherwise we double count the tax. expenses and assets values shown in the financial accounts. All projects will change the revenues. OH Tax payable S&D etc. c) The effect on variability of cash flows and earnings. Investment decision can have an impact on the cash flow position of the company and causes cash flows to fluctuate or to stabilise the cash flows.Sales Disposal proceeds x x - x - x - x - Cash outflows Initial outlay Mat. then the greater the variability. issuing costs. dividends. including investment in working capital. Therefore the effect on the overall riskiness of the business must also be considered before an investment decision can be made.How would this profit be affected if there is a change in the cost of money? Decision making After all this analysis and all others surrounding circumstances being considered. 5.How fast can the capital be recovered? . Operating cash flows – includes all income statement items except non-cash items and non-trading items. [all these are NOT relevant for investment appraisal] 3. a decision can be made whether to accept any of the project or not. Net cash flow x (x) x x x x x x x x x x x x x x x Types of cash flows for investment appraisal: 1. Payback period = Year before payback + Cumulative net cash flow before payback . lab. Then due care must be taken to ensure that the effects on short-term profit should be minimised to protect the shareholders interest. When considering whether a project is worthwhile. This is used for tax calculation purposes later. b) The effect on reported profit and earnings. because projects with longer payback period are riskier as cash flows estimates in the future years has a greater tendency to be wrong than those arising in the earlier years. redemption premium. If it causes fluctuation.

e.e. easy to explain and understand . Even if it is still ignoring cash flows payback. Even if a standard is set by the company in order to compare with the payback periods of different projects. therefore minimise risk to the company . and will not be distorted by assorted accounting conventions . both the returns and profitability are ignored .It lacks objectivity and cannot give a decision.It ignores cash flows after payback. In this case it will always provide a similar accept and reject decision as NPV criterion even though the ranking may be different.Simple to compute. Discounted payback = Year before payback + Cumulative PV before payback PV of CF in year of payback b) Payback reciprocal – the reciprocal of the payback period expressed as a percentage. Limitations of payback: . only ranking of projects is possible but decision still cannot be made. Net present value (NPV) This is the sum of PV of cash inflows and PV of cash outflows. then under perfect market condition. but it is useful in most circumstances especially when the NPV of projects are positive.Its accuracy depends on a very large extent the accuracy of its components . the NPV is the amount by which the total value of all issued shares is expected to increase by.It uses cash flows and not profits. i. NPV is the immediate increase in wealth resulting from acceptance of a project. 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.It takes into account the time value of money when discounting the cash flows at the basic capital .It does not take into account the time value of money . Those cash flows arising in the future that has been adjusted for the cost of money is termed present value.It is an absolute measure of cash flow surplus and therefore not distorted by any mathematical analysis .It is a rough measure of risks. 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 in wealth of the company’s shareholders. in certain circumstances approximates the IRR of the project.Cash flow in the year of payback Advantages of payback: .It is particularly useful in environment where technology changes very fast then a quick payback is essential before the investment in plant is obsolete.The discount rate used in order to arrive at the NPV may be enhanced by incorporating the effects of tax. If the company is listed / quoted on the Stock Exchange. and may be computed on an off-the-text basis Limitations of NPV: .Rapid payback also maximise cash flows and accelerate growth of the company by reinvesting in profitable investment . i. and helpful in determining the acceptability of a project. It is the amount. fast payback is less risky. over and above the cost of the project that you can borrow and know that the cash flows from the project will repay the whole loan.It’s sometimes difficult to explain to non-financial managers . inflation and risk. Advantages of NPV: .

It examines the profitability on investment and not just profit and therefore useful in situation of capital rationing.It is a relative measure and therefore not suitable in ranking mutually exclusive projects of different sizes.It is relatively insensitive to changes in the discount rate and will provide the same answer in spite of fluctuation and therefore.Prepare the schedule of net cash flows as usual . . This may be overcome by computing the extended yield of IRR.Add the present value of these negative cash flows to the initial outlay . . It is that discount rate at which the NPV will become zero. it may not be possible to compute the NPV until the cost of capital figure is known. . IRR = Discount rate + NPV at that discount rate 1% change Advantages of IRR: .Some patterns of cash flows do not have an IRR.It suffers from the same problem as NPV in the determination of suitable discount rate to be used in calculating present value. or invested externally. Limitations of PI: .It is expressed in term of percentage and therefore most managers can relate to it. Procedures for calculation of extended yield of IRR: . It therefore measures the sensitivity of the NPV to changes in the discount rate. . PI = NPV / Capital invested or PV of inflows / PV of outflows Advantages of PI: .It provides a rough measure of risk because it represents the buffer between the project cash flows and the company cost of capital. may provide a different ranking with the NPV calculation especially the cash flows profiles of different projects intersect.It takes into account the time value of money when utilising present values in its calculation.- Practically.The IRR cannot cope with interest changes.The IRR for certain type of cash flows are capable of more than one result because the IRR equation is polynomial. but the information relating to the determination of cost of capital will become available only after the treasury department 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. The decision criteria under IRR is to accept projects so long as their IRR are higher than the company’s cost of capital.Discount only future negative cash flows at the cost of capital .It is expressed as a percentage and therefore most managers can relate to it.It is a relative measure and therefore not suitable in ranking mutually exclusive projects of different sizes. . Limitations of IRR: . . Profitability index (PI) PI is a measure of profitability of an investment by comparing the NPV with the capital invested.It is not suitable to be used in making decision under multi-periods capital rationing situation.Rewrite the net cash flow schedule . Internal rate of return (IRR) The IRR measures the sensitivity of NPV to changes in the cost of capital. . and this makes it difficult to interpret the cut-off of break-even. .It does not need the cost of capital value initially for it to be computed. . .

If with alternative use but not a scarce resource. This can be calculated by compounding all the cash flows by the relevant cost of capital until the end of project life. 2. 6. then to calculate the present value of all cash flows and divide them using the annuity factor to determine the annual equivalent cash flow. It is expressed as a percentage and therefore most managers can relate to it. discount the annual equivalent cash flows until infinity to make a decision. 2. 3. (b) Future costs – those costs to be incurred in the future Future variable costs are always relevant unless committed or contracted. Variations of formulas exist and no one absolute consistent and accurate formula. 5. easy to explain and understand. then the replacement cost is relevant. It expresses the profits from a project as a percentage of capital cost. This is particularly useful if the management wants to know the cumulative cash flows after the end of project to undertake other activities. It cannot give a decision. Accounting information does not consider the relevancy of costs and revenue. 4. to calculate the cumulative future cash flows after deducting the investment costs when we terminate the project at the end of the project life. Also. ARR = Average annual profits after depreciation before interest x 100% Initial capital cost or Average capital cost Advantages of ARR: 1. Accounting policies are not consistent for different firms. It takes into accounts the capital cost of project by relating return to investment costs. Net terminal value (NTV) To calculate the terminal value of the project. 5. is also called sunk cost and is not relevant. It relates the return on the project to other accounting information and ratios. Limitations of ARR: 1. then the original cost and opportunity cost is also relevant. i. It is simple to calculate.- Compute the IRR as usual To evaluate projects with different lives or different discount rates For projects with different lives. 4. But those with a recovery value or scrap value then the scrap value is relevant. 6. It ignores the working capital requirements. if it is a scarce resource.e. 3. 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 . It does not take into accounts of the timing of cash flows and the time value of money. Accounting principles and concepts can be more easily understood and accepted. Future fixed costs are always irrelevant especially allocations and apportionment unless specific or incremental fixed costs. Accounting rate of return (ARR) The ARR is also sometimes called the Return on Capital Employed. Accounting information is easily and cheaper to obtain. 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. Future common costs are those that will always be incurred irrespective of alternative chosen and is not relevant unless in mutually exclusive financial decision. AEC = NPV / Annuity factor For projects with different discount rate.

It eliminates the confusion created by two IRR because modified IRR can obtain only one result. .Incremental cash flows earned by the project will attract extra tax liability (cash outflow). this is unlikely to be true because we are not going to invest the cash flows we earned from a project into the same project but may be into other project. and current tax rate applies. Whereas modified IRR assumed that we can re-invest the cash flows we earned from a project at the company’s cost of capital. . .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. and then discount these money cash flows using the money cost of capital. 2. once adjusted for the effects of inflation they are called money cash flows. for example: .Modified IRR can be calculated to determine the actual IRR of a project especially useful in situation where the project has more than one IRR because modified IRR calculation will only result in one IRR. and committed cost or contracted costs. This is more reasonable because the returns from any new project will be return to the company to be used for other investments. Fisher effect: (1 + RCC) (1 + F) = (1 + MCC) . The cash flows estimates in the original budget are stated in terms of current prices.Amount s paid as Advance corporation Tax (ACT) . . Adjustment for inflation effects: Inflation is a fall in value of money. however it is rarely used by companies in practice.Capital allowances. .Losses available for set-off or not. .The company’s accounting period. . This may be overcome by compounding the cash flows in the original capital budget at the specific rates of inflation that affect each items of revenue and expenditure. The estimation of cash flows can be distorted if the different variables in the capital budget are affected by different rates of inflation. Adjustment for tax effects: Tax normally has two effects on capital budgeting.Taxable profits are net project operating cash flows.All tax effects are assumed to arise one year in arrears unless question stated otherwise.The taxable profits and tax rate. It is of critical importance to the capital budgeting process because the capital outlay is quite often immediate with the cash inflows being earned over the project life. . Note that some cash flows will never be affected by inflation for example cash flows arising immediately like disposal proceeds..Ignore ACT. Unless information to the contrary.The qualifying capital expenditure will have tax saved on capital allowances (cash inflow).Assume sufficient taxable profits in other areas of the company to absorb the taxable losses arising from the project. The assumption is better – Normal IRR assumed we can re-invest cash flows earned from a project at the IRR. . initial investment etc. and is claimed to be a more superior method than other investment appraisal techniques. the following assumptions should be adopted: . these are called real cash flows. The advantages of modified IRR are: 1. The effects of tax are very complex. and tax payment dates. Modified IRR combines the advantages of IRR and NPV into a single calculation.

80 per unit. Selling price and costs are all in current price terms. at the end of which time it will be sold for $5000. (b) Calculate the before-tax return on capital employed (accounting rate of return) based on the average investment and comment on your findings.00 per unit and the variable cost of production is expected to be $7. Incremental annual fixed production overheads of $25000 per year will be incurred. Trevor Co has a target return on capital employed of 20%. Selling price and costs are expected to increase as follows: Increases 3% per year 4% per year 6% per year Selling price of Product T: Variable cost of production Fixed production overheads Other information: Trevor Co has a real cost of capital of 5. Trvor Co expects demand for Product T to be as follows: Year Demand (units) 1 35000 2 40000 3 50000 4 25000 The selling price for Product T is expected to be $12.7% and pays tax at an annual rate of 30% one year in arrears. This machine will cost $250000 and last for four years. Required: (a) Calculate the net present value of buying the new machine and comment on your findings (work to the nearest $1000). Product T.Note 1: Cash flows can be given in year 0 or year 1 prices. Depreciation is charged on a straight line basis over the life of an asset. It can claim capital allowances on a 25% reducing balance basis. General inflation is expected to be 5% per year. . 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.

could be bought for $800000 payable immediately. and describe how sensitivity analysis and probability analysis can be used to incorporate risk into the investment appraisal process.4 million 2 1. ‘Quago’. Tutorial Question Q1.00 per kilogram. Required: (a) Calculate the net present value of buying the new machine and advice on the acceptability of the proposed purchase (work to the nearest $1000) (b) Calculate the internal rate of return of buying the new machine and advice on the acceptability of the proposed purchase (work to the nearest $1000) (c) Explain the difference between risk and uncertainty in the context of investment appraisal. . The long-term finance of the company.90 per kilogram.6 million 4 1. increasing by $20000 per year in each subsequent year of operation. Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital allowances (tax-allowable depreciation) on a 25% reducing balance basis.5 million 3 1. It has a cost of equity of 11% and a before-tax cost of debt of 8. consists of 80% equity and 20% debt.(c) Discuss the strengths and weaknesses of internal rate of return in appraising capital investments. Duo Co needs to increase production capacity to meet increasing demand for an existing product. which is used in food processing. The scrap value of the machine after four years would be $30000. with a useful life of four years and a maximum output of 600000 kg of Quago per year. Forecast demand and production of Quago over the next four years is as follows: Year Demand (kg) 1 1.6%. on a market-value basis. A balancing allowance is claimed in the final year of operation. Other variable costs of production are $1. Duo Co uses its after-tax weighted average cost of capital when appraising investment projects.00 per kilogram and the variable cost of materials is $5.7 million Existing production capacity for Quago is limited to one kilogram per year and the new machine would only be used for demand additional to this. The current selling price of Quago is $8. Fixed costs of production associated with the new machine would be $240000 in the first year of production. A new machine.

SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax is reduced by capital allowances on machinery (tax-allowable depreciation).Q2. Producing and selling product P will call for increased investment in working capital. which SC Co can claim on a straight-line basis over the four-year life of the proposed investment. Selling price inflation is expected to be 4% per year and variable cost inflation is expected to be 5% per year. The machine is expected to cost $1 million. No increase in existing fixed costs is expected since SC Co has spare capacity in both space and labour terms. The new machine is expected to have no scrap value at the end of the four-year period. while the variable cost of the product (in current price terms) will be $12 per unit. Analysis of historical levels of working capital within SC Co indicates that at the start of each year. investment in working capital for product P will need to be 7% of sales revenue for that year. . (b) Calculate the internal rate of return of the proposed investment in product P. (d) Discuss how the net present value method of investment appraisal contributes towards the objective of maximising the wealth of shareholders. which has a short product lifecycle due to rapidly changing technology. SC Co is evaluating the purchase of a new machine to produce product P. SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes. Production and sales of product P are forecast to be as follows: Year Production and sales (units/year) 1 35000 2 53000 3 75000 4 36000 The selling price of product P (in current price terms) will be $20 per unit. Required: (a) Calculate the net present value of the proposed investment in product P. (c) Advice on the acceptability of the proposed investment in product P and discuss the limitations of the evaluations you have carried out.

(2) Value of the firm under the M&M no-tax model (graph). Borrowing will create a fix commitment to service interest whether profit is being made or not. There are two different theories on capital structure:a) Modigliani & Miller view (or net operating income view) b) Traditional View (or net income view) (A)Modigliani and Miller Theory (A)Modigliani In 1958. It discusses on how much of the company’s capital should come from the equity shareholders and how much of the capital should be raised through borrowing which described the relationship between debt and equity using gearing ratio.e. The increase in risk due to financing is called financial risk.CHAPTER 5: CAPITAL STRUCTURE Capital Structure Theory is concerned about the appropriate mix of financing of a business. This magnifies the fluctuation in the residual profits available for distribution to the equity shareholders i. . there is no optimum capital structure. It is to be distinguished from systematic business risk which every business is affected by however it is financed. tax free. (1) The cost of debt. they become more risky.e. Modigliani & Miller (M&M) put forward a static. equity & WACC under the M&M no-tax model (graph). Their argument 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 by the debt and equity ratio i. partial equilibrium valuation theory. Gearing is said to exist whenever a company is financed partly by borrowing.

The effects of tax is ignored which can further affect the cost of borrowing because corporate borrowing is always tax deductible and is not the case for individuals. Assumptions of Modigliani & Miller 1. 7. No limited liability. Arbitrage is a process of selling shares in a company with the lower value of WACC (overvalued company) and buying shares in the company with the higher value of WACC (undervalued company). Personal borrowing is having same cost as corporate borrowing. 5. 7. Firms can be grouped into similar risk classes. 4. Investors are rational and risk averse. 6. No transaction cost. therefore equilibrium will not be achieved. 3. 2. Modigliani & Miller revised their earliest conclusion to admit that the existence of taxation and tax allowances on interest does lower the cost of borrowing but the cost of capital will continue to drop up to 99% gearing. 3. 6.Note . Corporate borrowings do not have the same cost as personal borrowing because corporate borrowing often enjoys better terms. In 1963. Modigliani & Miller with tax (graph) . Capital markets are perfect and in equilibrium. If the cost of debt were to increase at extreme level of gearing. 4.The cost of debt remains unchanged as gearing is increased. . the cost of equity must drop so that WACC remains constant which is impossible to occur. 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 own account. Criticisms of Modigliani & Miller 1.The cost of equity rising in a manner that leaves the WACC always constant due to a capital arbitrage. 8. Market imperfection are deep-rooted and systematic. No bankruptcy cost. 5. 2. All investors have similar expectation about the future. There is substantial amount of transaction costs involved in the arbitrage process. It is unlikely that the cost of debt will remain constant especially when the gearing is becoming too high and institutional investors may be reluctant to lend money beyond certain gearing ratio.

Agency costs will increase as gearing increases which may be higher than the tax shield obtained from the extra debt financing. financial managers should seek based on experience where it is. 3. for company that cannot take advantage of the tax saved.e. If the company is too highly geared. the extreme level of gearing is to be ignored which is unlikely to give rise to minimum cost of capital. The size of the organization. i. The tax position of the company. Organisation’s perception of its debt capacity. Because of personal tax where the tax on interest income may be too high. impossible to tell what is the optimum borrowing ratio whereas Modigliani & Miller concludes that a company should borrow as much as possible as long as it is acceptable to the equity shareholders. . The implication of bankruptcy costs (i. and then the tax shield should be reduced accordingly. Countries in which the fund will be invested and borrowed. The compromise between Traditional View and Modigliani and Miller Theory is that. The current view by Brealey and Myers is that the amount a company can borrow will depend on: 1. If a company is financed wholly by equity. Reasons why companies cannot have 99% gearing 1. the expected present value of cost of financial distress) may be too high due to greater risk of bankruptcy. The company may exhaust its corporate tax liability short of 99% gearing.e.e. there is probably a very broad area where the optimum gearing will lie. the increase in the financial risk will increase the cost of capital which will be undesirable. 6. it is very hard if not. 7.Value of the firm. The view of the providers of capital as to the acceptable level of gearing. Therefore. the increase in gearing is not worthwhile. Therefore. if the tax saved on debt interest by the company is less than the tax payable by investors. 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 an ungeared company because of the present value of tax saved on interest on borrowing. it will lose out the opportunity of using some cheap sources of debt financing. The level of healthy profit (cash flows) that can be generated by the company. 5. The amount of strong asset base as collateral. based on its ability to repay such debt. in between the extreme. i. 5. 4. Institutional investors may be reluctant to lend any further money beyond certain level of gearing. 3. 2. 2. Conclusion The Traditional View concludes that a company should borrow at the optimum borrowing ratio but in practice. 4.

e. . then a company should introduce borrowing into its capital structure so that the WACC will be lower due to the introduction of cheap debt into the capital structure. and then the cost of equity will increase. cost of equity and the overall cost of capital and maintain the gearing at that particular level just before the cost of capital increases. If the company is all equity financed. but if the company increase the borrowing to a higher level which is believed to be too high. At that point the cost of capital is minimized and the value of company is maximized i. In traditional theory. the following points can be observed:1. A finance manager should therefore push the gearing at that level just before the overall cost of capital is increasing. 3. the lender of debt financing will also reappraise the risk in the business and the cost of debt will also increase.(B) The Traditional View In traditional view. 6. The cost of capital and the value of the firm with taxes and financial distress as gearing increases (graph) is shown as below:- From the graph. 5. the shareholders’ wealth are maximized. After a period of time which is not related to the equity time zone. It also reflects the fact that the market will not react and adjust immediately for the increase in financial risk. then the cost of debt will increase and the cost of equity will also increase due to the higher level of financial risk. As the company’s gearing increases. it is believed that the cost of equity and cost of debt is independent of each other and that every company has an optimum capital structure. The finance manager should therefore monitor the pace of increase in cost of debt. the cost of capital will be equal to the cost of equity. 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 introduction of cheap debt capital into the capital structure. the equity shareholders will re-appraise the risk of the company due to the increase in financial risk. 2. 4. Since debt financing is cheaper. since debt financing is cheaper than equity finance (because interest paid on debt is tax deductible).

25 Required: (a) Calculate the expected annual return to shareholders under each of the capital structures.000 $160.000 $300.0 12.0 Cost of debentures (net of tax) percentage --4.0 7. The company therefore wishes to raise $10 million.0 8.0 18.2 million.000 Probability 0.5 4. Tutorial Question Eastwell Plc is to be established shortly.000 with an interest rate of 12 %.00 (b) Selling 300.000 shares at $2. CHAPTER 6: FINANCIAL INSTRUMENTS .00 and borrowing $400. (c) Identify the optimal capital structure for the company and discuss the value of using information of this sort for such a purpose.00 and borrowing $800.50 0. (b) Calculate the earnings per share and the expected market value of each $1 share to be issued by the company at each of these levels of gearing.000 shares at $2. you have ascertained that the cost of capital of the company would depend upon its capital structure as follows: Gearing Percentage 0 10 20 30 40 50 60 Cost of equity percentage 12.Example Newly Established Plc has recently been formed to take advantage of a major investment opportunity which will cost $10 million.5 14.5 13.5 16. After discussions with financial analysts.5 Required: (a) Calculate the weighted average cost of capital for the company at each of the above prospective levels of gearing.0 13. and has consulted you as to the proportion which should be raised through ordinary shares and debentures respectively. (c) Selling 100.0 6. The founders are considering their options with regard to capital structure.000 shares at $2.000 at an interest rate of 13%.7 5. There are three possible outcomes for the future annual cash flows before interest: Success of product Poor Good Excellent Note: Taxes may be ignored Cash flow before interest $60. and is expected to generate annual profits of $1. A total of $1 million will be needed to establish the business and the three ways of raising these funds being considered are: (a) Selling 500.25 0. (b) Calculate the standard deviation of the expected annual return under each of the capital structures.

however. Annuities are relatively safe. including stocks and bonds. low-yielding investments. money market instruments or some combination of these. the stock price may fall and you could lose some or all of the money you invested. When you purchase a CD. A mutual fund manager invests your funds in securities. If the company does poorly. thereby. If the company does well. They offer many of the services that checking accounts offer. They are also insured by the FDIC. Earnings cannot be withdrawn without penalty until a specified age and are taxed only at the time of withdrawal. Bond terms can range from a few months to 30 years. sharply reducing your risk. Bonds are tradable instruments and are generally considered a safer than stocks because bondholders are paid before stockholders if a company becomes bankrupt. • Mutual Funds A mutual fund is generally a professionally managed pool of money from a group of investors. usually after retirement. based upon the fund’s investment objectives. They are very safe and provide easy access to your money. • Money Market Deposit Accounts These accounts generally earn higher interest than savings accounts. • Annuities Annuities are contracts sold by an insurance company designed to provide payments to the holder at specified intervals. Just like savings accounts. your funds are fully insured. They provide easy access to your money and are generally insured. An annuity has a death benefit equivalent to the higher of the current value of the annuity or the amount the buyer has paid into it. • Stocks When you buy stocks. CDs are also insured up to $100. Independent bond-rating agencies rate the likelihood that any given bond will default. By investing in a mutual fund you can diversify.Basic Types of Financial Instruments • Savings Accounts Savings accounts are a safe haven to store your emergency funds. you own a part of the company’s assets. • Bonds A bond is a certificate of debt issued by the government or a company with a promise to pay a specified sum of money at a future date and carries interest at a fixed rate. Most mutual funds charge fees. . a limit is normally placed on the number of withdrawals or transfers you can make during a given period of time.000 or less. higher is the interest rate. The chief drawback of such accounts is that interest rates tend to be low since they offer a very high degree of safety. you may receive periodic dividends and/or be able to sell your stock at a profit.000. you invest a fixed sum of money for fixed period of time. You often pay income tax on your profits. • CDs (Certificates of Deposit) A CD is a special type of deposit account that typically offers a higher rate of interest than a regular savings account. Usually. the longer the period. There are penalties for early withdrawal. If you or your family’s deposit accounts at one FDIC-insured bank or savings association total $100.

1. Selling a futures contract commit the firm to sell certain commodity at a specified price on some date in the future. Buying a currency futures commit the firm to buy certain units of a currency at a specified rate on some date in the future. and (c) Delivery dates – end of March.000 British pounds for next December at a rate previously agreed upon. before the price rises. The firm will make a gain when price of goods rises if it bought a futures contract. A UK firm will take a position in the future market such that if the event that it fears on a trader occurs. The firm will make a gain when price of goods falls if it sold a futures contract. in the case of privately negotiated contract. Buying a futures contract commit the firm to buy certain commodity at a specified price on some date in the future. A futures contract is entered into through an organised exchange. These contracts are settled through organised exchanges and they have clearing houses.This is the type of currency that is defined as forward transactions that have standard sizes as well as dates of maturity. on the futures market this may be possible. A special feature of futures is that they are not specifically designated for specific transaction and therefore readily marketable. A Futures Contract is an agreement to buy or sell any commodity on some future date at a price agreed today. before the price falls. Selling a currency futures commit the firm to sell certain units of a currency at a specified rate on some date in the future. The Futures have been standardized and usually they are traded on the exchange rates created for such purpose. The contracts usually include interest of any amount. A futures contract is similar to the forward contract except that it is standardised as to the: (a) Amount (b) Quality. In summary to the above. it may not be possible to transfer the contract to another party. which may be financial institutions or part of the futures exchange.Types of Financial Instruments There are many kinds of financial instruments in the foreign exchange market that are widely used today. The contract has an average length of 3 months roughly. a futures price incorporates the market’s belief about the likely movement of an asset’s underlying price. Futures . However. using banks and brokers. September and December Futures are traded at the London International Financial Futures Exchange (LIFFE). it will make a gain as a future dealer. The clearing houses act . June. One example is 500.

a foreign currency or a financial instrument since the contract value and underlying price change symmetrically. currency or other underlying asset. Depending upon the nature of the instruments. Forward transaction is also known as forward contract. time to expiry and underlying asset. Expiry date is the date specified in the futures contract. Duration of trading could be carried out in a few days.Another way to deal with the risk of the Foreign exchange is to deal in a transaction termed as forward transaction.as intermediaries between the buyer and the seller. 2. commodity or a financial instrument. A forward contract is defined as an agreement made today between a buyer and seller to exchange a specified instrument for a specified quantity at a predetermined future date. For example. he can enter into a forward contract to . coffee etc) Forward contracts are often used to hedge adverse movements in currencies. at the end of which it will cease to exist. Cost of carry is the relationship between futures prices and spot prices that can be summarised in terms of what is known as the cost of carry. irrespective of whether the price increases or decreases. if a party expects an appreciation in the currency rate in which he is required to pay in future. The settlement price of a futures contract converges towards the futures price on the delivery date. at a price agreed upon today. 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. 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 Futures terminology Spot price is the price at which an underlying asset trades in the spot market. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the 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. guarantee obligations and make futures liquid with low credit risk. Contract cycle is the period over which a future contract trades. The forward rate is determined at the time of entering into the contract but the settlement of the contract happens at a future date mentioned in the contract. The price agreed is called the “forward rate”. This is also known as lot size. the contract has to be settled by delivery of the underlying asset. The specified instrument could be a commodity. � Each contract is custom-designed and hence is unique in terms of contract size. months and even years. This is the last day on which the contract will be traded. and this is regardless of what the rates in the market would be then. Futures contracts are used to hedge the entire price change of a commodity. futures contracts may have one-month. Futures price is the price at which the futures contract trades in the futures market. Contract size is the amount of asset that has to be delivered under one contract. rubber. In this type of transaction. one's money doesn't change the hands actually not until there is an agreed upon date in the future. Forward Transaction . The buyer and the seller agree on an exchange rate for a date anytime in the future. � On the date of expiry. two-month or three-month expiry cycles. and the deal occurs on that particular date.

The spot market is the source for the data of this study. In a forward contract. no part of the contract is standardised and the two parties meet and agree every detail of the contract before signing it.This type of transaction is defined by its two-day delivery which when compared to the future type of contracts that have the duration of usually three months. 3. Swaps are mainly classified as currency swaps and interest rate swaps. The size of the swap is referred to as the notional amount and is the basis for calculation. These streams are called the legs of the swap. for instance foreign currency rate risk. The interest is exclusive in the agreed transaction.protect him from loss on account of foreign exchange fluctuation. The cash flows are calculated over a notional principal amount. One of these parties is usually the bank or a financial institution. The spot trade represents the "direct exchange" between two kinds of currencies. In other words. The two parties agree to reverse the trade at a certain later date. The currency swap consists of two parties exchanging currencies for a period of time. in itself is neither borrowing nor lending. Net working capital is the value of current assets less the current liabilities in any given period. it represents that part of current assets which is financed by long-term finance. A swap. Objective .This is the most common kind of forward transaction. Foreign currency forward contracts are used as a foreign currency hedge when an investor has an obligation to either make or receive a foreign currency payment at a future date. The Swap however is not considered as contracts and swaps are not traded through the exchange. Swap . 4. It involves money or cash rather than the contract. Spot . a swap can be defined as a bilateral OTC (over-the-counter) derivative contract in which two parties exchange one stream of future cash flows for another stream of cash flows over a period of time. Swaps are often used to hedge certain risks. The spot has the shortest length of time. CHAPTER 7: WORKING CAPITAL MANAGEMENT Introduction Working capital refers to the current assets that are maintained by a business to allow for smooth business operation.

Retained earnings .Other money markets borrowing . Examples: .Bank loans . Typically current assets represent more than half of assets of companies. This comprises the fixed assets and permanent current assets.Determining the level of investment in individual components of working capital. Working capital management requires decisions to be made in two areas: . $’000 2350 2550 2950 2750 2800 3350 2700 2500 Now Year 1 Q1 Q2 Q3 Year 2 Q1 Q2 Q3 Q4 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? . .Letter of credit for trade financing . These fluctuations may be financed by short-term finance and stand-by credits. credit policy and cash balances.Working capital management is used to refer to the management of all aspects of both current assets and current liabilities. to minimise the risk of insolvency while maximising the return on assets.Overdrafts .e. i. The total investment must then be matched and equated with the longterm sources of finance which usually are: .Bankers’ acceptances . they tend to be of particular importance to small firms.Trade credits Example (a) WC Ltd has projected the following balances for its current assets over the next two years. stock levels.New issue of securities either shares or debentures Seasonal variation in selling activity may cause stock and debtors’ balances to fluctuate.Determining the approach to an appropriate mix of financing to such investment Financing strategy for working capital Firms may adopt one of the three approaches to the financing of working capital: (a) Matching concept (b) Conservative approach (c) Aggressive approach Matching Approach Most firms should normally attempt to identify the long-term investment in the company.

on the money market or Europe market. for example. Decision relating investment levels The other aspect of working capital management is to answer question such as: . but also part of the permanent current assets. Another reason for such approach can occur when the company is anticipating a large amount of cash flows that can be generated from operations and therefore expecting such excess short-term finance can be repaid easily without affecting the liquidity of the company.4 million Year 2 $0. Such a strategy may be used during time when short-term finance is relatively cheaper than long-term finance. it may lead the long-term money in the business to help part finance of the fluctuating current assets.(b) Additional information: Retained earnings will be 55% of profits after tax Profits after tax Year 1 $0. This would obviously result in time period where the firm would have surplus funds. Aggressive approach A company may adopt a more aggressive approach in financing by using short-term and standby credit to finance not only the fluctuating current assets.6 million Required: How much will be required to be raised through bank loans? Conservative approach When a company is able to accumulate long-term funds (usually from retained earnings) and does not immediately wish to repay any existing long-term borrowing. Good finance manager should make an effort to invest this money in marketable securities or callable money.

to prevent stock-out by meeting unexpected fluctuation in demand . usage of one complete container .Rental and maintenance of warehouse .Obsolescence cost .Staff salary .Sales are evenly distributed throughout the year and not seasonal .as a hedge against potential increase in price .the credit policy That can maximise contribution and requirement of cash balances from time to time.Transportation and material handling cost . Inventory control Firms need to maintain stocks for the following reasons: .Insurance during transport .Cost of stock return The traditional view has been to equate the ordering costs with the carrying costs to arrive at the lowest possible total inventory cost.to lend smoothness to business operation The costs involved are in two main areas: (a) Total Carrying Costs (TCC) . Assumptions of EOQ .Sales can be predicted with reasonable accuracy .to fulfil transport requirement of supplier..the optimal stock level . for example.to take advantage of quantity discount .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 annum O is the fixed cost per order h is the holding cost per unit for a year h = cost per unit x storage cost % . It has been believed that this can be achieved by identifying a batch size or order quantity that will equate TOC with TCC to arrive at the optimal TIC.The ordering costs are fixed irrespective of the size of the order .Insurance .Administrative cost of issuing purchase requisition and receiving supply .Interest cost of capital tied up in stock .Pilferage cost (b) Total Ordering Costs (TOC) .The carrying cost of stock are all variable .

TIC and ROL if: (a) There is no safety stock? (b) There is safety stock? 360.50 20% $375 3% of average stock value 5 days 3 days . = D/Q. TOC = DO/Q TCC = hA where A is the average stock value = Q/2. Required: What is the EOQ.TOC = NO where N is the number of orders p. TCC = hQ/2 TIC = TOC + TCC ROL = Lead time x demand If there is safety stock EOQ = 2DO/h TOC = DO/Q TCC = hA = hQ/2 + h(safety stock) TIC = TOC +TCC ROL = (Lead time + safety stock provision) demand Example Demand per annum Selling price per unit Profit margin Fixed cost per order Storage costs Lead time Safety stock provision Assume 360 days per annum. TCC. TOC.a.000 units $12.

0 10.8 3.11 13.6 6.3 2004 $m 132.3 1.7 36.0 30.4 3.69 2005 $m 145.5 3.0 120.1 $4.Tutorial Questions Question 1 The following financial information relates to Merton Plc.3 23.9 4.6 $5.0 $2.70 10.7 3.6 5.0 95.8 6.3 39.7 1.4 1.5 2.0 105.5 Turnover Cost of sales Operating expenses Operating profit Interest Profit before tax Taxation Profit after tax Dividends Share price at 30 April: Balance Sheets as at 30 April.0 3. Profit and loss accounts for the years ended 30 April are as follows: 2006 $m 160.7 5.0 40. a supplier of photographic equipment and film services to the film industry.5 1.3 9.0 12. .7 26.1 7.

000 per year would be achieved as a result of factoring. The Finance Director believes that a rights issue would be a 1 for 2 rights issue at a 20% discount to the current share price.000 per year. with a reduction to no more than the average for the sector within two years. Merton currently pays interest on its overdraft at an annual rate of 4%. The Finance Director has also been assured that bad debts. would fall by 80%. but it believes that the additional capital needed would be at least $19 million. also said that Merton Plc is considering expanding into the retail camera market.000. Merton Plc has not issued any new shares for the last three years.45 (on an ex dividend basis) where it has remained. the company’s share price fell from $2. currently standing at $500. although this rate is variable. It also believes that the expansion will generate an after-tax return of 9% per year. The Finance Director decided when taking up his appointment that substantial improvement was needed in the area of working capital management and asked the factoring subsidiary of a major bank to provide a quotation for non-recourse factoring. The factor has indicated that it would require an annual fee of 0. Following the announcement. The rights issue would be underwritten by the issuing house for a fee of $300. but he is concerned that the recent fall in the company’s share price may cause many shareholders to decide against taking up their rights. The newly-appointed Finance Director has suggested a rights issue to finance the proposed expansion.5% of sales. Savings in current administration costs of Merton Plc of $100.Fixed Assets Current Assets Stock Debtors Cash Current Liabilities Trade creditors Overdraft Net current assets Total assets less current liabilities Long-term liability 10% debentures 2008 8% debenture 2013 2006 $m $m $m 45 36 41 1 78 17 8 2005 $m $m $m 35 32 24 16 72 11 1 25 53 98 13 25 12 60 95 13 25 38 60 38 57 Capital and Reserves Ordinary shares (50 cents par) Reserves 10 50 60 10 47 57 Note: All sales are on credit.70 to $2. . The announcement. It expects the average time taken by debtors to pay to fall immediately to 75 days. Shareholders of Merton Plc have been alarmed by the company’s recent announcement that it intends to cut the total dividend for the year. as a result of which it expects future share price growth and dividend growth to be at least 8% per year. The Board of Merton Plc has not announced how it plans to finance the proposed expansion into the retail camera market. which was released on 1 June 2006. It would advance Merton Plc 80% of the face value of sales at an interest rate 1% above the current overdraft rate.

Credit purchases in each year were 95% of cost of sales. Turnover Cost of sal es Gross profi t Admi ni strati on expenses Profi t before i nterest and tax Interest Profi t before tax Balance Sheets. Anjo Plc pays interest on its overdraft at an annual rate of 8%. Clearly identify any issues that you consider should be brought to the attention of the ordinary shareholders. 2006 $000 15600 9300 6300 1000 5300 100 5200 2005 $000 11100 6600 4500 750 3750 15 3735 2006 $000 Fixed Assets Current Assets St ocks Debtors Cash Current liabilities Trade creditors Overdraft Total assets less current liabilities $000 5750 $000 2005 $000 5400 3000 3800 120 6920 2870 1000 3870 8800 1300 1850 900 4050 1600 150 1750 7700 All sales were on credit. Current sector averages are as follows: Stock days 90 days . comment on: (a) The view of the Finance Director that substantial improvement is needed in the area of working capital management of Merton Plc.The Finance Director has collected the following average data for the media sector: Return on capital employed Gross profit margin Net profit margin Interest cover Gearing (Debt / Equity using book values) 12% 25% 8% 50% Stock days 100 days Debtor days 60 days Creditor days 50 days 8 times Current ratio 3.5 times Required: Using appropriate ratios and financial analysis. (b) The recent financial performance of Merton Plc from a shareholder perspective. Question 2 Extracts from the recent financial statements of Anjo Plc are as follows: Profit and Loss account.5 times Quick ratio 2. Anjo Plc has no long-term debt.

STANDARD COSTING & VARIANCE ANALYSIS – Additional notes Standard Costing definitions Standard is a predetermined measureable quantity set in defined conditions Standard cost is a standard expressed in money. (c) Discuss the relationship between working capital management and business solvency. and explain the factors that influence the optimum cash level for a business. Standards are designed to reflect the future and are most suitable for decision making. (i) Stock days (ii) Debtor days (iii) Creditor days (b) Calculate the length of the cash operating cycle (working capital cycle) for each year and explain its significance. valuing stocks and establishing selling prices. . with no allowances for normal losses. control by exception reporting. Variance analysis is the analysis of performance by means of variances that is used to promote management action at the earliest possible stages.Debtor days Creditor days 60 days 80 days Required: (a) Calculate the following ratios for each year and comment on your findings. Variance accounting is a method by which planned activities are compared with actual results to provide information for variance analysis. it is known as potential standard. Ideal standard is a standard which can be attained under the most favourable conditions. budgeted or standard costs and actual costs (similar for revenue). Ratios may be calculated to measure efficiency. a machine properly operated or a material properly used. Uses of standard costs Planning As standards are pre-determined and plans relate to future periods of time. Variance is the difference between planned. Attainable standard is a standard which can be attained if a standard unit of work is carried out efficiently. waste and machine downtime. standards are used for the preparation of budgets. Decision making Decisions relate to future periods of time and will affect future outcomes. It is built up from an assessment of the value of cost elements. waste and machine downtime. Allowances are made for normal losses. Financial accounting Standard costs are often used as the basis for stock valuations for inclusion in financial accounts. Also. Its main uses are for providing bases for performance measurement. Control Standards are compared with actual results and variances calculated are analysed to provide information for control. Performance evaluation The performance of managers may be measured according to their ability to achieve the standards set.

� To assist in setting budgets. operational / planning. � Quantity type variances are always valued at standard values. revising and monitoring standards encourages reappraisal of methods. � Standard costing variance analysis is primarily concerned with asking “what costs should be” for the actual level of output (and not for the budgeted level of output) � Variances can relate to either quantities or values. � To provide guidance on possible ways of improving performance. Interpretation concerns deciding the significance of variances and corrective action will be taken if significant. they provide a simpler basis of inventory valuation. materials and techniques so leading to cost reductions.objectives � To provide a formal basis for assessing performance and efficiency.Principles applied in variance calculations � Variance analysis. and interdependence. management’s attention is directed towards those items which are not proceeding according to plan. 2. Standard costs represent what the parts and products should cost. They are not merely averages of past performances and consequently they are a better guide to pricing than historical costs. A properly developed standard costing system with full participation and involvement creates a positive. � To control costs by establishing standards and analysing variances. and price type variances are always based on actual quantities. Standard costing is an example of management by exception. By studying the variances. Standard costing –advantages 1. 3. size (relative terms). � Significance depends on size (absolute terms). and as a basis for pricing where “cost-plus” systems are used. as represented by standards or budgets. In addition. � The standard costs are readily available substitutes for actual average unit costs. so that management can take appropriate action. profit planning and decision-making. � To provide a basis for estimating. favourable / adverse. � Variances must be interpreted. � To assist in assigning responsibility for non-standard performances in order to correct defiencies or to capitalize on benefits. cost effective attitude through all levels of management right down to the production floor and thereby increases motivation and goal congruence. � To motivate staff and management. in general. 4. The process of setting. Standard costing . and can be used for stock and work-in-progress valuations. Management are able to delegate cost control through the standard costing system knowing that variances will be reported. is fundamentally concerned with taking differences between actual results achieved and yardsticks. � To enable the principle of “management by exception” to be practised at the detailed operational level. .

In volatile conditions.Standard costing – disadvantages 1. Virtually all aspects of standard setting involve forecasting and subjective judgements. 4. 5. with rapidly changing methods. 3. 2. if identical or similar circumstances occur in the future. Elaborate variances may be imperfectly understood by line managers and are unlikely to be effective for control purposes. As the past cannot be altered the only value variances can have. Material variances (a) Material cost variance AMC SMC for AO (AQ x AP) (SQ for AO x SP) (b) Material price variance (AP SP) AQ consumed AMC (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 Labour variances (a) Labour cost variance ALC SLC for AO (AH x AR) (SH for AO x SR) (b) Labour rate variance (AR SR) AH paid ALC (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 . standards quickly become out of date and thus lose their control and motivational effects. This can cause resentment and loss of internal goodwill. This implies stable. is to guide management. This problem may be overcome by using planning and operational variances but will mean more subjectively and also more work. rates and prices. with inherent possibilities of error and argument. repeating situations which is not always a reflection of reality. All forms of variance analysis are post-mortem of past events. It may be time consuming and expensive to install and to keep up to date.

Fixed overhead variances (a) Total fixed overhead variance AF O/H incurred SF O/H for AO AF O/H incurred (SH for AO x FOAR) (b) Fixed overhead expenditure variance AF 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 Variable overhead variances (a) Total variable O/H variance A VO/H incurred S VO/H for AO A VO/H incurred (SH for AO x VOAR) (b) V O/H expenditure variance A VO/H incurred A VO/H absorbed A VO/H incurred (AH worked x VOAR) (c) V O/H efficiency variance (AH worked SH for AO) VOAR Sales (margin) variance (a) Total sales (M) variance Actual Quantity Sold x Actual SP – Std cost [A profit/unit] (b) Selling price variance (ASP SSP) AQ Sold A 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 Budgeted Quantity x Standard SP – Std cost [S profit/unit]) .

3.05 Standard material quantity per unit of production 8 kg 2.00 $168.000 per month at a . the standard hourly rate for direct workers is set at $4. During the week to be analysed the team was made up as follows: Number 10 6 12 Grades Skilled Semi-skilled Unskilled Actual wages paid $348. using the following information:Actual cost of materials used $2400 Production (units) 295 Actual usage 1920 kg Standard cost per kilogram $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. Favad Ltd makes a single product and operates a system of variance accounting.00 $302. The standard composition of a team of workers is as follow:Number of workers 10 6 12 Grades of labour Standard hourly rate of pay skilled 85 cents semi-skilled 70 cents unskilled 60 cents There is a guaranteed 40 hour week and the standard output for the week is 200 components. In Department X.40 The number of components produced during the week was 215 despite a mechanical breakdown which lasted 2 hours and a delay in the delivery of materials causing a further hold up of one hour.Tutorial Questions 1. Fixed overhead in the department is budgeted to cost $165.50 per hour and each unit of product requires 6 standard hours in the department. Calculate the labour variances and present them in a suitable form to the production manager.

750. Overhead amounted to $525.000 Labour 10.300.normal monthly level of production of 5. There is no opening or closing work-inprogress. KC Chemicals Limited produce an industrial purifying agent known as Kleenchem. the budgeted weekly output/sales of which is 10.000 units of product Planned hours 10. the standard cost per 100 litres being: Material 250 kg costing 50 cents per kg Labour 4 hours at $1. 4. the invoiced value being $14. A company controls its manufacturing operations by a system of standard costing. Required: Use the foregoing information to produce an operating statement for the week ending 26 November in standard costing format.000 units of product.000 Variance statements Actual production Material Price Variance Material Usage Variance Labour Rate Variance Labour Efficiency Variance 45. During last month. The material input was 24.25 per hour Overhead $5 (budgeted absorption of fixed cost) The standard selling price is $1.000 Material 50.000kg $50.650.125 (F) $2.625 (A) $1.350 and fixed overhead incurred in the department was $158.000 litres. Required: (a) Calculate the total direct labour cost variance and analyse it into appropriate sub-variances. . (b) Calculate the total fixed overhead cost variance and analyse it into appropriate sub-variances.000 units of product $7. Extracts from the original budgets and variance statements for a nationally distributed product show: Budgets Planned production 500.500 (F) Required: State the: (i) Actual quantity used (kg) (ii) Actual price per kg (iii) Actual hours worked (iv) Labour rate increase above budget 5.50 per one-litre container. costing $124. Production employees booked 380 hours to the process and were paid $490.860 litres all of which were sold. direct workers worked 26800 hours.720 kg which cost $12. 4650 units of product were made.500 (A) $2.000 hours x $6 $60. During the week ended 26 November the output of Kleenchem was 9.

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