Basics of Managerial Accounting

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Basics of Managerial Accounting

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Management accounting or managerial accounting is the process of identifying, analyzing, recording and presenting

financial information that is used for internally by the management for planning, decision making and control.

In contrast to financial accounting, managerial accounting is concerned with providing helpful information and reports to

internal users such as managers and entrepreneurs etc. so that they can control and plan the business activities. Few of the

main areas, in which managerial accounting is used are:

Planning and Budgeting: Managers use managerial accounting techniques to plan what to sell, how much to sell,

what price is to be charged to reimburse the costs of production and also earn an optimal profit. Also they have to

plan how to finance the operations and how to manage cash etc. This is very important to keep the business

operations working smoothly. The capital budgeting and master budget are the two important topics in this area.

Decision Making: When managers have to decide whether or not to start a particular project, they need

managerial accounting information to estimate the benefits of various opportunities and decide which one to

choose. Mangers often use relevant costing techniques.

Measurement of Performance: Managers have to compare the actual results of operations to budgeted figures to

evaluate the performance of the business. They use managerial accounting techniques such as standard costing to

evaluate the performance of specific departments. They then make necessary adjustments in those departments

which are not performing well.

Financial vs. Managerial Accounting

Although financial accounting and managerial accounting are closely related and work side by side but they are different on

following aspects:

Users: Users of financial accounting information are people outside the organization such as stockholders,

government, investors, etc. The users of managerial accounting information are people inside the organization for

example managers and entrepreneurs.

Time: Financial accounting is mainly concerned with past business activities. Financial accounting is used to record

the actual facts and figures of financial transactions. Although managerial accounting does involve the analysis of

past business activities to evaluate departmental performance, it is also concerned with future planning and

budgeting.

Regulation: Financial accounting practices are governed by GAAP and IFRS etc. Since financial accountants have to

report about the financial performance of the business to external users therefore it is very necessary to enforce

such regulations to provide correct information to people outside the organization. Managerial accounting is not

governed by such rules and regulations.

Requirement by Law: Registered companies are required by law to produce and publish financial accounting

information. But managerial accounting is not mandatory by law. It is only required internally.

Cost and Cost Classifications

Cost is a sacrifice of resources to obtain a benefit or any other resource. For example in production of a car, we sacrifice

material, electricity, the value of machine's life (depreciation), and labor wages etc. Thus these are our costs.

Costs are usually classified as follows:

Product Costs Vs Period Costs

Product costs are costs assigned to the manufacture of products and recognized for financial reporting when sold. They

include direct materials, direct labor, factory wages, factory depreciation, etc.

Period costs are on the other hand are all costs other than product costs. They include marketing costs and administrative

costs, etc.

Breakup of Product Costs

The product costs are further classified into:

Direct materials: Represents the cost of the materials that can be identified directly with the product at

reasonable cost. For example, cost of paper in newspaper printing, cost of

Direct labor: Represents the cost of the labor time spent on that product, for example cost of the time spent by a

petroleum engineer on an oil rig, etc.

Manufacturing overhead: Represents all production costs except those for direct labor and direct materials, for

example the cost of an accountant's time in an organization, depreciation on equipment, electricity, fuel, etc.

The product costs that can be specifically identified with each unit of a product are called direct product costs whereas

those which cannot be traced to a specific unit are indirect product costs. Thus direct material cost and direct labor cost are

direct product costs whereas manufacturing overhead cost is indirect product cost.

Prime Costs Vs Conversion Costs

Prime costs are the sum of all direct costs such as direct materials, direct labor and any other direct costs.

Conversion costs are all costs incurred to convert the raw materials to finished products and they equal the sum of direct

labor, other direct costs (other than materials) and manufacturing overheads.

Cost Classification Diagram

COSTS

PRODUCT COSTS

(COST OF GOODS SOLD)

PERIOD COST

(OPERATING EXPENSES)

DIRECT MATERIAL COST DIRECT LABOUR COST OVERHEAD COST

PRIME COSTS

CONVERSION COSTS

Fixed Costs Vs Variable Costs

Fixed costs are costs which remain constant within a certain level of output or sales. This certain limit where fixed costs

remain constant regardless of the level of activity is called relevant range. For example, depreciation on fixed assets etc,.

Variable costs are costs which change with a change in the level of activity. Examples include direct materials, direct labor,

etc.

Sunk Costs Vs Opportunity Costs

The costs discussed so far are historical costs which means they have been incurred in past and cannot be avoided by our

current decisions. Relevant in this regard is another cost classification, called sunk costs. Sunk costs are those costs that

have been irreversibly incurred or committed; they may also be termed unrecoverable costs.

In contrast to sunk costs are opportunity costs which are costs of a potential benefit foregone. For example the opportunity

cost of going on a picnic is the money that you would have earned in that time.

Direct Costs and Indirect Costs

Manufacturing costs may be classified as direct costs and indirect costs on the basis of whether they can be attributed to

the production of specific goods, services, departments or not.

Direct Costs

Direct costs can be defined as costs which can be accurately traced to a cost object with little effort. Cost object may be a

product, a department, a project, etc. Direct costs typically benefit a single cost object therefore the classification of any

cost either as direct or indirect is done by taking the cost object into perspective. A particular cost may be direct cost for

one cost object but indirect cost for another cost object.

Most direct costs are variable but this may not always be the case. For example, the salary of a supervisor for a month who

has only supervised the construction of a single building is a direct fixed cost incurred on the building.

Examples: Cost of gravel, sand, cement and wages incurred on production of concrete.

Indirect Costs

Costs which cannot be accurately attributed to specific cost objects are called indirect costs. These typically benefit multiple

cost objects and it is impracticable to accurately trace them to individual products, activities or departments etc.

Examples: Cost of depreciation, insurance, power, salaries of supervisors incurred in a concrete plant.

Example

Following costs are incurred by a factory on the production of identical cupboards:

1. Laborers' wages 2. Synthetic wood

3. Power consumption 4. Glass

5. Nails and screws 6. Factory insurance

7. Handles, locks and hinges 8. Wood

9. Supervisors' salaries 10. Factory depreciation

11. Varnish, glue, paints 12. Factory manager's salary

Classify the above costs as direct or indirect.

Solution

1. Direct 2. Direct

3. Indirect 4. Direct

5. Indirect 6. Indirect

7. Direct 8. Direct

9. Indirect 10. Indirect

11. Indirect 12. Indirect

Cost Accounting Systems

A cost accounting system (also called product costing system or costing system) is a framework used by firms to estimate

the cost of their products for profitability analysis, inventory valuation and cost control.

Estimating the accurate cost of products is critical for profitable operations. A firm must know which products are profitable

and which ones are not, and this can be ascertained only when it has estimated the correct cost of the product. Further, a

product costing system helps in estimating the closing value of materials inventory, work-in-progress and finished goods

inventory for the purpose of financial statement preparation.

There are two main cost accounting systems: the job order costing and the process costing.

Job order costing is a cost accounting system that accumulates manufacturing costs separately for each job. It is

appropriate for firms that are engaged in production of unique products and special orders. For example, it is the costing

accounting system most appropriate for an event management company, a niche furniture producer, a producer of very

high cost air surveillance system, etc.

Process costing is a cost accounting system that accumulates manufacturing costs separately for each process. It is

appropriate for products whose production is a process involving different departments and costs flow from one

department to another. For example, it is the cost accounting system used by oil refineries, chemical producers, etc.

There are situations when a firm uses a combination of features of both job-order costing and process costing, in what is

called hybrid cost accounting system.

In a cost accounting system, cost allocation is carried out based on either traditional costing system or activity-based

costing system.

Traditional costing system calculates a single overhead rate and applies it to each job or in each department.

Activity-based costing on the other hand, involves calculation of activity rate and application of overhead costs to products

based on their respective activity usage.

Based on whether the fixed manufacturing overheads are charged to products or not, cost accounting systems have two

variations: variable costing and absorption costing. Variable costing allocates only variable manufacturing overheads to

inventories, while absorption costing allocates both variable and fixed manufacturing overheads to products. Variable

costing calculates contribution margin, while absorption costing calculates the relevant gross profit.

Still further refinement to costing accounting systems include JIT-costing, back-flush costing.

Activity-Based Costing

Activity-based costing is a method of assigning indirect costs to products and services which involves finding cost of each

activity involved in the production process and assigning costs to each product based on its consumption of each activity.

Activity-based costing is more refined approach to costing products and services than the traditional costing method. It

involves the following steps:

Identification of activities involved in the production process;

Classification of each activity according to the cost hierarchy (i.e. into unit-level, batch-level, product level and

facility level);

Identification and accumulation of total costs of each activity;

Identification of the most appropriate cost driver for each activity;

Calculation of total units of the cost driver relevant to each activity;

Calculation of the activity rate i.e. the cost of each activity per unit of its relevant cost driver;

Application of the cost of each activity to products based on its activity usage by the product.

Cost Hierarchy

The first step in activity-based costing involves identifying activities and classifying them according to the cost hierarchy.

Cost hierarchy is a framework that classifies activities based the ease at which they are traceable to a product. The levels

are (a) unit level, (b) batch level, (c) product level, and (d) facility level.

Unit level activities are activities that are performed on each unit of product. Batch level activities are activities that are

performed whenever a batch of the product is produced. Product level activities are activities that are carried out

separately for each product. Facility level activities are activities that are carried out at the plant level. The unit-level

activities are most easily traceable to products while facility-level activities are least traceable.

Example

Alex Erwin started Interwood, a niche furniture brand, 10 years ago. He ran the business as a sole proprietorship. While he

has 50 skilled carpenters and 5 salesmen on his payroll, he has been taking care of the accounting by himself. Now, he

intends to offer 40% of the ownership to public in next couple years, and is willing to make changes and has hired you as

the management accountant to organize and improve the accounting systems.

Interwood's total budgeted manufacturing overheads cost for the current year is $5,404,639 and budgeted total labor

hours are 20,000. Alex applied traditional costing method during all of the 10 years period, and based the pre-determined

overhead rate on total labor hours.

Interwood's sofa range includes the 2-set, 3-set and 6-set options. Platinum Interiors recently placed an order for 150 units

of the 6-set type. The order is expected to be delivered in 1 month time. Since it is a customized order, Platinum will be

billed at cost plus 25%.

You are not a fan of traditional product costing system. You believe that the benefits of activity-based costing system

exceeds its costs, so you sat down with Aaron Mason, the chief engineer, to identify the activities which the firm

undertakes in its sofa division. Next, you calculated the total cost that goes into each activity, identified the cost driver that

is most relevant to each activity and calculated the activity rate. The results are summarized below:

Activity

(in $)

A

Relevant Cost Driver

B C=A/B (in $)

Production of components 2,313,132 Machine hours 25,000 93

Assembly of components 1,231,312 Number of labor hours 20,000 62

Packaging 213,123 Units 5,000 43

Shipping 231,230 Units 5,000 46

Setup costs 34,243 Number of setups 240 143

Designing 123,132 Designer hours 1,000 123

Product testing 24,234 Testing hours 500 48

Rent 1,234,233 Labor cost $1,645,644 75%

Once the order was ready for packaging, Aaron gave you a summary of total cost incurred and a statement of activities

performed (also called the bill of activities) as shown below:

Order No: 15X2013, Customer: Platinum Interiors, Units: 150, Type: 6 unit, Amounts in $

Cost of direct materials 25,000

Cost of purchased components 35,000

Labor cost 15,600

Activity Relevant Cost Driver Activity Usage

Production of components Machine hours 320

Assembly of components Number of labor hours 250

Packaging Units 150

Shipping Units 150

Setup costs Number of setups 15

Designing Designer hours 70

Testing hours 22

Rent Labor cost 4500

Part A

Calculate the total cost of the order and the invoice value of the order based on traditional costing system.

Solution

In the traditional costing system, cost equals materials cost plus labor cost plus manufacturing overheads charged at the

pre-determined overhead rate.

The pre-determined overhead rate based on direct labor hours = $5,404,639/20,000 = $270 per labor hour

The actual number of labor hours spent on the order is 250. Once we have this data, we can estimate the manufacturing

overheads and the total cost as follows:

Direct materials 25,000

Purchased components 35,000

Labor cost 15,600

Manufacturing overheads ($270 250) 67,500

Total cost under traditional product costing system 143,100

Platinum is billed at cost plus 25%, so the amount of sales to be booked would amount to $178,875 (= $143,100 1.25).

Part B

You know activity-based costing is a more refined approach. Now, since you have all the data needed, calculate the order

cost using activity based costing.

Solution

In activity-based costing, direct materials cost, cost of purchased components and labor cost remains the same as in

traditional product costing. However, the value of manufacturing overheads assigned is more accurately estimated. The

following worksheet estimates the manufacturing overheads that should be assigned to the order of Platinum Interiors:

(A) (B) (A B)

Activity Activity Rate Activity Usage Activity Cost Assigned

Production of components 93 320 29,760

Assembly of components 62 250 15,500

Packaging 43 150 6,450

Shipping 46 150 6,900

Setup costs 143 15 2,145

Designing 123 70 8,610

Product testing 48 22 1,056

Rent 75% 15,600 11,700

82,121

Total cost of the order is hence:

US$

Direct materials 25,000

Purchased components 35,000

Labor cost 15,600

Manufacturing overheads 82,121

Total cost under activity-based costing 157,721

Based on the more accurate estimation of the order cost, the invoice should be raised at $197,150 (=$157,721 1.25)

instead of $178,875 calculated under traditional product costing system.

The example highlights the importance of correct estimation of the product cost and the usefulness of activity-based

costing in achieving that goal.

Cost Allocation

Cost allocation or cost assignment is the process of allocating of overhead costs to costs objects. Cost object may be a

product, a department or a project. Unlike direct costs, overheads cannot be traced directly to specific cost objects.

Indirect costs are assigned to cost objects using an allocation base called cost driver. Floor area, direct labor hours, machine

hours etc. may be used as cost drivers.

Cost pool is a group of costs which have been assigned to a cost object using a single cost driver.

In this chapter we will learn:

1. Allocation of individual costs to costs centers.

2. Allocation of service department costs.

3. Allocation of costs to individual products.

Service Department Cost Allocation

Since service departments do not generate revenue themselves and they help other departments, all their costs must be

allocated again to other departments. This will be a simple task provided that none of the service departments provides

services to other service department(s). Things are complicated when service departments receive services from each other

(which is most often the case).

The problem here is that the cost reallocation process of two service departments, both of which benefit from each other,

will repeat itself because each of them will receive a portion of reallocated service department costs which have to be

allocated again and again. Assume a company has a certain number of production departments and two service

departments, A and B, and that both of them receive services from each other. If we reallocate service department A's cost

first and service departments B's cost later, department A's balance will no longer remain zero because it will receive a

portion of reallocated cost of department B. Thus, we will be forced to repeat the process many times.

Following are the four techniques for reallocation of service department costs for use in the situation described above:

1. Simultaneous Equation Method

2. Repeated Distribution Method

3. Specific Order of Closing Method

4. Direct Allocation Method

Repeated Distribution Method

Repeated distribution method is a technique in which costs of each service department are repeatedly allocated to other

departments according to the given percentages until the balance left in service departments reaches zero.

Assume a company has a certain number of production departments and two service departments, A and B, which benefit

from each other. In order to reallocate the service department costs to production departments using repeated distribution

method, we follow the steps given below:

1. Start by allocating the higher service cost first, let it be A.

2. Allocate department B's costs to all production departments and department A.

3. Since the balance in department A no longer remains zero after reallocation of department B's cost we have to

repeat the process by allocating department A's cost again to production departments and department B.

4. This process of reallocating the service department costs is repeated until the balance remaining in any service

department becomes negligible.

Example

The following example illustrates the repeated distribution method:

ltd. has three production departments (P, Q and R) and two service departments (X and Y). The total overheads for the

departments are given below:

Department Overheads

P $35,000

Q $64,000

R $19,000

X $22,000

Y $38,000

The reallocation percentages of the service departments' costs are given below:

Department P Q R X Y

X 20% 25% 25% 10%

Y 25% 30% 30% 15%

Reallocate the service department costs in the specified percentages using repeated distribution method.

Solution

Department P Q R X Y

Allocated Overheads 35,000 64,000 19,000 22,000 38,000

Dept. X Reallocation 4,400 5,500 5,500 (22,000) 2,200

Total 39,400 69,500 24,500 0 40,200

Dept. Y Reallocation 10,050 12,060 12,060 6,030 (40,200)

Total 49,450 81,560 36,560 6,030 0

Dept. X Reallocation 1,206 1,508 1,508 (6,030) 603

Total 50,656 83,068 38,068 0 603

Dept. Y Reallocation 151 181 181 90 (603)

Total 50,807 83,248 38,248 90 0

Dept. X Reallocation 18 23 23 (90) 9

Total 50,825 83,271 38,271 0 9

Dept. Y Reallocation 2 3 3 1 (9)

Total 50,827 83,274 38,274 1 0

We stop when the balance left in service departments becomes negligible.

Simultaneous Equation Method

In simultaneous equation method of allocation of service department costs, we establish simultaneous equations and solve

them to obtain the final balances of production departments. This method accurately allocates service department costs in

the given percentages.

Simultaneous equation method is best explained using an example.

Example

In this example we use simultaneous equation method to solve the same problem we solved earlier using repeated

distribution method. Following is the problem:

Y ltd. has three production departments (P, Q and R) and two service departments (X and Y). The total overheads for the

departments are given below:

Department Overheads

P $35,000

Q $64,000

R $19,000

X $22,000

Y $38,000

The reallocation percentages of the service departments' costs are given below:

Department P Q R X Y

X 20% 25% 25% 10%

Y 25% 30% 30% 15%

Use the simultaneous equation method to allocate the service department overheads to production departments.

Solution

Let,

x = total overheads of department X after reallocation

y = total overheads of department Y after reallocation

Then total overhead of department X will be 22,000 + 15% of department Y overhead after reallocation whereas the total

overhead of department Y will be 38,000 + 10% of department X overhead after reallocation. Therefore,

x = 22,000 + 0.15y

y = 38,000 + 0.10x

Solving the above equations for x and y we get:

Total overheads of department X after reallocation = x 28,122

Total overheads of department Y after reallocation = y 40,812

The total overheads as calculated above are allocated to production departments in specified percentages as shown below:

Department P Q R

Initial Overheads 35,000 64,000 19,000

Dept. X Reallocation 5,624 7,030 7,030

Dept. Y Reallocation 10,203 12,244 12,244

Total Overheads 50,827 83,274 38,274

Specific Order of Closing Method

Specific order of closing method (also known as sequential method) is one of the techniques used to reallocate service

departments' overheads to production departments. As the name suggests, it reallocates service department overheads in

certain order.

Under specific order of closing method, we reallocate the overheads of the largest service department first and then the

overheads of the second largest service department and so on. The overheads of service departments are reallocated to

production departments as well as other service departments but once the overheads of a service department are

reallocated, it does not receive any reallocations back from other service departments. In this way, the balances in service

departments reach zero in fewer steps than the repeated distribution method.

There is a major drawback however. Since there are no reallocations back, the service department overheads are not

apportioned among service departments accurately according to the specified percentages.

The following example illustrates the specific order of closing method:

Example

Y ltd. has three production departments (P, Q and R) and two service departments (X and Y). The overheads before

reallocation are given below:

Department Overheads

P $35,000

Q $64,000

R $19,000

X $22,000

Y $38,000

The reallocation percentages of the service departments' costs are given below:

Department P Q R X Y

X 20% 25% 25% 10%

Y 25% 30% 30% 15%

Use the specific order of closing method to reallocation the service department costs to

Solution

Since service department Y has large overheads than department X therefore we will reallocate department Y costs first to

all production departments and service department X. Then we will reallocate department X costs only to production

departments because in specific order of closing method we don't allocate costs back to a service department whose costs

have already been reallocated. To transfer all the costs of service department X, we apportion department X costs of

$27,700 after reallocation of department Y's cost among the three production departments in the ratio existing between

their percentages from department X.

Thus, department P will get 40%/90% $27,700 and department Q and R will get 25%/90% $27,700 each.

Department P Q R X Y

Allocated Overheads 35,000 64,000 19,000 22,000 38,000

Dept. Y Reallocation 9,500 11,400 11,400 5,700 (38,800)

Total 44,500 75,400 30,400 27,700 0

Dept. X Reallocation 12,311 7,694 7,694 (27,700)

Total 56,811 83,094 38,094 0

Direct Allocation Method

Direct allocation method is one of the four techniques used to reallocate service departments' overheads to production

departments. It is different from the other reallocation methods because it completely disregards any services provided by

one service department to another. This means that no portion of the overhead of a service department is reallocated to

other service departments. All is reallocated to production departments in the ratio of their specified percentages.

Direct method is generally an inaccurate method of service departments' overheads reallocations and very inaccurate when

service departments receive significant help from each other. Therefore it is only recommended in cases where service

departments do not depend much on the services of other departments.

Direct allocation method is better explained using an example.

Example

Let us use the same problem we used earlier:

Y ltd. has three production departments (P, Q and R) and two service departments (X and Y). The overheads for the

departments before reallocation are given below:

Department Overheads

P $35,000

Q $64,000

R $19,000

X $22,000

Y $38,000

The reallocation percentages of the service departments' costs are given below:

Department P Q R X Y

X 40% 25% 25% 10%

Y 25% 30% 30% 15%

Use the direct allocation method to reallocate the overheads of service departments to production departments.

Solution

First we have to calculate the factors to apportion service department overheads:

Department Sum of Percentages P Q R

X 40+25+25=90 40/90 25/90 25/90

Y 25+30+30=85 25/85 30/85 30/85

We then multiply the service department overhead by the above factors to obtain the amount of overhead to be allocated

to each production department.

Department P Q R X Y

Allocated Overheads 35,000 64,000 19,000 22,000 38,000

Dept. X Reallocation 9,778 6,111 6,111 (22,000)

Dept. Y Reallocation 11,176 13,412 13,412

(38,000)

Total 55,954 83,523 38,523 0 0

Types of Costs by Behavior

Cost behavior refers to the way different types of production costs change when there is a change in level of production.

There are three main types of costs according to their behavior:

Fixed Costs:

Fixed costs are those which do not change with the level of activity within the relevant range. These costs will incur even if

no units are produced. For example rent expense, straight-line depreciation expense, etc.

Fixed cost per unit decreases with increase in production. Following example explains this fact:

Total Fixed Cost $30,000 $30,000 $30,000

Units Produced 5,000 10,000 15,000

Fixed Cost per Unit $6.00 $3.00 $2.00

Variable Costs:

Variable costs change in direct proportion to the level of production. This means that total variable cost increase when

more units are produced and decreases when less units are produced. Although variable in total, these costs are constant

per unit. For example

Total Variable Cost $10,000 $20,000 $30,000

Units Produced 5,000 10,000 15,000

Variable Cost per Unit $2.00 $2.00 $2.00

Mixed Costs:

Mixed costs or semi-variable costs have properties of both fixed and variable costs due to presence of both variable and

fixed components in them. An example of mixed cost is telephone expense because it usually consists of a fixed component

such as line rent and fixed subscription charges as well as variable cost charged per minute cost. Another example of mixed

cost is delivery cost which has a fixed component of depreciation cost of trucks and a variable component of fuel expense.

Since mixed cost figures are not useful in their raw form, therefore they are split into their fixed and variable components

by using cost behavior analysis techniques such as High-Low Method, Scatter Diagram Method and Regression Analysis.

Cost Volume Formula

Cost volume formula is a cost accounting relation used to estimate production cost of a given number of units of a product.

A linear cost volume formula is of the following form:

y = a + bx

In the above equation,

y stands for total production cost;

a for total fixed cost;

b for variable cost per unit; and

x for number of units

Total Fixed Cost is the sum of pure fixed cost, such as rent on factory building and property taxes; and the fixed component

of mixed costs, such as total fixed cost on delivery trucks i.e. straight line depreciation expense.

Variable Cost per Unit is the sum of pure variable cost per unit, such as material cost per unit; and the variable component

of mixed cost, such as variable cost per unit on delivery trucks i.e. fuel expense.

For this purpose, mixed costs are split into their fixed and variable components by using any of the following techniques:

1. High-Low Method

2. Scatter Graph Method

3. Regression Method

The cost volume formula we discussed here is in the form of linear equation. Cost volume formulas can also be quadratic or

other complex forms which are more accurate and thus suitable for practical use.

Example

Find total fixed cost, variable cost per unit, total cost of producing 30,000 units from the following cost volume formula:

y = $43,000 + 6x

Solution

Total Fixed Cost = $43,000

Variable Cost per Unit = $6

Total Cost of Producing 30,000 Units = $43,000 + 6 30,000 = $223,000

High-Low Method

High-Low method is one of the several techniques used to split a mixed cost into its fixed and variable components (see

cost classifications). Although easy to understand, high low method is relatively unreliable. This is because it only takes two

extreme activity levels (i.e. labor hours, machine hours, etc.) from a set of actual data of various activity levels and their

corresponding total cost figures. These figures are then used to calculate the approximate variable cost per unit (b) and

total fixed cost (a) to obtain a cost volume formula:

y = a + bx

High-Low Method Formulas

Variable Cost per Unit

Variable cost per unit (b) is calculated using the following formula:

Variable Cost per Unit =

y

2

y

1

x

2

x

1

Where,

y

2

is the total cost at highest level of activity;

y

1

is the total cost at lowest level of activity;

x

2

are the number of units/labor hours etc. at highest level of activity; and

x

1

are the number of units/labor hours etc. at lowest level of activity

The variable cost per unit is equal to the slope of the cost volume line (i.e. change in total cost change in number of units

produced).

Total Fixed Cost

Total fixed cost (a) is calculated by subtracting total variable cost from total cost, thus:

Total Fixed Cost = y

2

bx

2

= y

1

bx

1

Example

Company wants to determine the cost-volume relation between its factory overhead cost and number of units produced.

Use the high-low method to split its factory overhead (FOH) costs into fixed and variable components and create a cost

volume formula. The volume and the corresponding total cost information of the factory for past eight months are given

below:

Month Units FOH

1 1,520 $36,375

2 1,250 38,000

3 1,750 41,750

4 1,600 42,360

5 2,350 55,080

Month Units FOH

6 2,100 48,100

7 3,000 59,000

8 2,750 56,800

Solution:

We have,

at highest activity: x

2

= 3,000; y

2

= $59,000

at lowest activity: x

1

= 1,250; y

1

= $38,000

Variable Cost per Unit = ($59,000 $38,000) (3,000 1,250) = $12 per unit

Total Fixed Cost = $59,000 ($12 3,000) = $38,000 ($12 1,250) = $23,000

Cost Volume Formula: y = $23,000 + 12x

Due to its unreliability, high low method is rarely used. The other techniques of variable and fixed cost estimation are

scatter-graph method and least-squares regression method.

Scatter Graph Method

Scatter graph method is a graphical technique of separating fixed and variable components of mixed cost by plotting

activity level along x-axis and corresponding total cost (mixed cost) along y-axis. A regression line is then drawn on the

graph by visual inspection. The line thus drawn is used to estimate the total fixed cost and variable cost per unit. The point

where the line intercepts y-axis is the estimated fixed cost and the slope of the line is the average variable cost per unit.

Since the visual inspection does not involve any mathematical testing therefore this method should be applied with great

care.

Procedure

Step 1: Draw scatter graph

Plot the data on scatter graph. Plot activity level (i.e. number of units, labor hours etc.) along x-axis and total mixed cost

along y-axis.

Step 2: Draw regression line

Draw a regression line over the scatter graph by visual inspection and try to minimize the total vertical distance between

the line and all the points. Extend the line towards y-axis.

Step 3: Find total fixed cost

Total fixed is given by the y-intercept of the line. Y-intercept is the point at which the line cuts y-axis.

Step 4: Find variable cost per unit

Variable cost per unit is equal to the slope of the line. Take two points (x

1

,y

1

) and (x

2

,y

2

) on the line and calculate variable

cost using the following formula:

Variable Cost per Unit = Slope of Regression Line =

y

2

y

1

x

2

x

1

Example

Company decides to use scatter graph method to split its factory overhead (FOH) into variable and fixed components.

Following is the data which is provided for the analysis.

Month Units FOH

1 1,520 $36,375

2 1,250 38,000

3 1,750 41,750

4 1,600 42,360

5 2,350 55,080

6 2,100 48,100

7 3,000 59,000

8 2,750 56,800

Solution:

Fixed Cost = y-intercept = $18,000

Variable Cost per Unit = Slope of Regression Line

To calculate slop we will take two points on line: (0,18000) and (3500,68000)

Variable Cost per Unit = (68000 18000) (3500 0) = $14.286

Least-Squares Regression Method

A mixed cost can be split into variable and mixed components by a statistical technique called simple linear regression

analysis. This technique mathematically calculates the y-intercept and the slope of a straight line that ideally fits through a

set of points on a graph. In least-squares method, the ideal fitting of the regression line is achieved by minimizing the sum

of squares of the distances between the line and all the points on the graph.

Formulas

In cost behavior analysis, the cost volume formula "y = a + bx", is equivalent to regression line. Its y-intercept (a) and slope

(b) represent the total fixed cost and variable cost per unit respectively, can be calculated by solved following simultaneous

linear equations of least-squares regression analysis:

By solving the above equations for total fixed cost (a) and variable cost per unit (b), we obtain:

Cost Volume Profit Analysis

Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that is concerned with the effect of sales volume

and product costs on operating profit of a business. It deals with how operating profit is affected by changes in variable

costs, fixed costs, selling price per unit and the sales mix of two or more different products.

CVP analysis has following assumptions:

1. All cost can be categorized as variable or fixed.

2. Sales price per unit, variable cost per unit and total fixed cost are constant.

3. All units produced are sold.

Where the problem involves mixed costs, they must be split into their fixed and variable component by High-Low Method,

Scatter Plot Method or Regression Method.

CVP Analysis Formula

The basic formula used in CVP Analysis is derived from profit equation:

px = vx + FC + Profit

In the above formula,

p is price per unit;

v is variable cost per unit;

x are total number of units produced and sold; and

FC is total fixed cost

Besides the above formula, CVP analysis also makes use of following concepts:

Contribution Margin (CM)

Contribution Margin (CM) is equal to the difference between total sales (S) and total variable cost or, in other words, it is

the amount by which sales exceed total variable costs (VC). In order to make profit the contribution margin of a business

must exceed its total fixed costs. In short:

CM = S VC

Unit Contribution Margin (Unit CM)

Contribution Margin can also be calculated per unit which is called Unit Contribution Margin. It is the excess of sales price

per unit (p) over variable cost per unit (v). Thus:

Unit CM = p v

Contribution Margin Ratio (CM Ratio)

Contribution Margin Ratio is calculated by dividing contribution margin by total sales or unit CM by price per unit.

Break-even Point Equation Method

Break-even is the point of zero loss or profit. At break-even point, the revenues of the business are equal its total costs and

its contribution margin equals its total fixed costs. Break-even point can be calculated by equation method, contribution

method or graphical method. The equation method is based on the cost-volume-profit (CVP) formula:

px = vx + FC + Profit

Where,

p is the price per unit,

x is the number of units,

v is variable cost per unit and

FC is total fixed cost.

Calculation

BEP in Sales Units

At break-even point the profit is zero therefore the CVP formula is simplified to:

px = vx + FC

Solving the above equation for x which equals break-even point in sales units, we get:

Break-even Sales Units = x =

FC

p v

BEP in Sales Dollars

Break-even point in number of sales dollars is calculated using the following formula:

Break-even Sales Dollars = Price per Unit Break-even Sales Units

Example

Calculate break-even point in sales units and sales dollars from following information:

Price per Unit $15

Variable Cost per Unit $7

Total Fixed Cost $9,000

Solution

We have,

p = $15

v = $7, and

FC = $9,000

Substituting the known values into the formula for breakeven point in sales units, we get:

Breakeven Point in Sales Units (x)

= 9,000 (15 7)

= 9,000 8

= 1,125 units

Break-even Point in Sales Dollars = $15 1,125 = $16,875

Break-even Point Contribution Margin Approach

The contribution margin approach to calculate the break-even point (i.e. the point of zero profit or loss) is based on the CVP

analysis concepts known as contribution margin and contribution margin ratio. Contribution margin is the difference

between sales and variable costs. When calculated for a single unit, it is called unit contribution margin. Contribution

margin ratio is the ratio of contribution margin to sales.

In this method simple formulas are derived from the CVP analysis equation by rearranging the equation and then replacing

certain parts with Contribution Margin formulas.

Contribution Approach Formulas

BEP in Sales Units

We learned that, at break-even point, the CVP analysis equation is reduced to:

px = vx + FC

Where p is the price per unit, x is the number of units, v is variable cost per unit and FC is total fixed cost.

Solving the above equation for x (i.e. Break-even sales units):

Break-even Sales Units = x = FC ( p v )

Since unit contribution margin (Unit CM) is equal to unit sale price (p) less unit variable cost (v), so,

Unit CM = p v

Therefore,

Break-even Sales Units = x = FC Unit CM

BEP in Sales Dollars

Break-even point in dollars can be calculated via:

Break-even Sales Dollars = Price per Unit Break-even Sales Units ; or

Break-even Sales Dollars = FC CM Ratio

Example

Calculate the break-even point in units and in sales dollars when sales price per unit is $35, variable cost per unit is $28 and

total fixed cost is $7,000.

Solution

Contribution Margin per Unit = ($35 $28) = $7

Break-even Point in Units = $7,000 $7 = 1,000

Break-even Point in Sales Dollars = 1,000 $35 or $7,000 20% = $35,000

Sales Mix Break-even Point Calculation

Sales mix is the proportion in which two or more products are sold. For the calculation of break-even point for sales mix,

following assumptions are made in addition to those already made for CVP analysis:

1. The proportion of sales mix must be predetermined.

2. The sales mix must not change within the relevant time period.

The calculation method for the break-even point of sales mix is based on the contribution approach method. Since we have

multiple products in sales mix therefore it is most likely that we will be dealing with products with different contribution

margin per unit and contribution margin ratios. This problem is overcome by calculating weighted average contribution

margin per unit and contribution margin ratio. These are then used to calculate the break-even point for sales mix.

The calculation procedure and the formulas are discussed via following example:

Example: Formulas and Calculation Procedure

Following information is related to sales mix of product A, B and C.

Product A B C

Sales Price per Unit $15 $21 $36

Variable Cost per Unit $9 $14 $19

Sales Mix Percentage 20% 20% 60%

Total Fixed Cost $40,000

Calculate the break-even point in units and in dollars.

Calculation

Step 1: Calculate the contribution margin per unit for each product:

Product A B C

Sales Price per Unit $15 $21 $36

Variable Cost per Unit $9 $14 $19

Contribution Margin per Unit $6 $7 $17

Step 2: Calculate the weighted-average contribution margin per unit for the sales mix using the following formula:

Product A CM per Unit Product A Sales Mix Percentage

+ Product B CM per Unit Product B Sales Mix Percentage

+ Product C CM per Unit Product C Sales Mix Percentage

= Weighted Average Unit Contribution Margin

Product A B C

Sales Price per Unit $15 $21 $36

Variable Cost per Unit $9 $14 $19

Contribution Margin per Unit $6 $7 $17

Sales Mix Percentage 20% 20% 60%

$1.2 $1.4 $10.2

Sum: Weighted Average CM per Unit $12.80

Step 3: Calculate total units of sales mix required to break-even using the formula:

Break-even Point in Units of Sales Mix = Total Fixed Cost Weighted Average CM per Unit

Total Fixed Cost $40,000

Weighted Average CM per Unit $12.80

Break-even Point in Units of Sales Mix 3,125

Step 4: Calculate number units of product A, B and C at break-even point:

Product A B C

Sales Mix Ratio 20% 20% 60%

Total Break-even Units 3,125 3,125 3,125

Product Units at Break-even Point 625 625 1,875

Step 5: Calculate Break-even Point in dollars as follows:

Product A B C

Product Units at Break-even Point 625 625 1,875

Price per Unit $15 $21 $36

Product Sales in Dollars $9,375 $13,125 $67,500

Sum: Break-even Point in Dollars $90,000

Contribution Margin

Contribution margin (CM) is the amount by which sales revenue exceeds variable costs. It can be calculated as contribution

margin per unit as well as total contribution margin, using the following formulas:

Unit CM = Unit Price Variable Cost per Unit

Total CM = Total Sales Total Variable Costs

Variable costs are those which vary in proportion to the level of production. Variable cost may be direct as well as indirect.

Direct variable cost includes direct material cost and direct labor cost. Indirect variable costs include certain variable

overheads.

Total contribution margin can also be obtained by multiplying unit contribution margin by number of units sold. Similarly,

contribution margin per unit can also be calculated by divided total contribution margin by number of units sold.

Contribution Margin Ratio

Contribution margin ratio is contribution margin as percentage of sales. It can be calculated as shown in the following

formula:

CM Ratio =

Unit Contribution Margin

=

Total Contribution Margin

Unit Price Total Sales

Contribution margin and contribution margin ratio are used in the breakeven analysis.

Example

Use the following information to calculate unit contribution margin, total contribution margin & contribution margin ratio:

Price Per Unit $22

Units Sold 802

Total Variable Cost $9,624

Solution

Total Sales = 802 $22 = $17,644

Total Contribution Margin = $17,644 $9,624 = $8,020

Contribution Margin Per Unit = $8,020 802 = $10

CM Ratio = $8,020 $17,644 = $10 $22 45%

Margin of Safety (MOS)

In break-even analysis, margin of safety is the extent by which actual or projected sales exceed the break-even sales. It may

be calculated simply as the difference between actual or projected sales and the break-even sales. However, it is best to

calculate margin of safety in the form of a ratio. Thus we have the following two formulas to calculate margin of safety:

MOS = Budgeted Sales Break-even Sales

MOS =

Budgeted Sales Break-even Sales

Budgeted Sales

Margin of Safety can be expressed both in terms of sales units and currency units.

The margin of safety is a measure of risk. It represents the amount of drop in sales which a company can tolerate. Higher

the margin of safety, the more the company can withstand fluctuations in sales. A drop in sales greater than margin of

safety will cause net loss for the period.

Example

Use the following information to calculate margin of safety:

Sales Price per Unit $40

Variable Cost per Unit $32

Total Fixed Cost $7,000

Budgeted Sales $40,000

Solution

Breakeven Sales Units = $7,000 ($40 - $32) = 875

Budgeted Sales Units = $40,000 $40 = 1,000

Margin of Safety = (1000 875) 1,000 = 12.5%

Relevant Costing

Relevant costing is a management accounting toolkit that helps managers reach decisions when they are posed with the

following questions:

1. Whether to buy a component from an external vendor or manufacture it in house?

2. Whether to accept a special order?

3. What price to charge on a special order?

4. Whether to discontinue a product line?

5. How to utilize the scarce resource optimally?

Relevant costing is an incremental analysis which means that it considers only relevant costs i.e. costs that differ between

alternatives and ignores sunk costs i.e. costs which have been incurred, which cannot be changed and hence are irrelevant

to the scenario.

Example

Company A manufactures bicycles. It can produce 1,000 units in a month for a fixed cost of $300,000 and variable cost of

$500 per unit. Its current demand is 600 units which it sells at $1,000 per unit. It is approached by Company B for an order

of 200 units at $700 per unit. Should the company accept the order?

Solution

A layman would reject the order because he would think that the order is leading to loss of $100 per unit assuming that the

total cost per unit is $800 (fixed cost of $300,000/1,000 and variable cost of $500 as compared to revenue of $700).

On the other hand, a management accountant will go ahead with the order because in his opinion the special order will

yield $200 per unit. He knows that the fixed cost of $300,000 is irrelevant because it is going to be incurred regardless of

whether the order is accepted or not. Effectively, the additional cost which Company A would have to incur is the variable

cost of $500 per unit. Hence, the order will yield $200 per unit ($700 minus $500 of variable cost).

Special Order Pricing

Special order pricing is a technique used to calculate the lowest price of a product or service at which a special order may

be accepted and below which a special order should be rejected. Usually a business receives special orders from customers

at a price lower than normal. In such cases, the business will not accept the special order if it can sell all its output at normal

price. However when sales are low or when there is idle production capacity, special orders should be accepted if the

incremental revenue from special order is greater than incremental costs.

This method of pricing special orders, in which price is set below normal price but the sale still generates some contribution

per unit, is called contribution approach to special order pricing. The idea is that it is better to receive something above

variable costs, than receiving nothing at all.

The following example is used to illustrate special order pricing:

Example

A company is producing, on average, 10,000 units of product A per month despite having 30% more capacity. Costs per unit

of product A are as follows:

Direct Material $8.00

Direct Labor 5.00

Variable Factory Overhead 2.00

Variable Selling Expense 0.50

Fixed Factory Overhead 3.00

Fixed Office Expense 2.00

$20.50

The company received a special order of 2,000 units of product A at $17.00 per unit from a new customer. Should the

company accept the special order, provided that the customer has agreed to pay the variable selling expenses in addition to

the price of the product?

Solution

The increment cost per unit for the special order is calculated as:

Direct Material $8.00

Direct Labor 5.00

Variable Factory Overhead 2.00

$15.00

Since the incremental cost per unit is less that the price offered in the special order, the company should accept it.

Accepting special order will generate additional contribution of $2.00 unit and $4,000 in total.

Make-or-Buy Decision

Make-or-Buy decision (also called the outsourcing decision) is a judgment made by management whether to make a

component internally or buy it from the market. While making the decision, both qualitative and quantitative factors must

be considered.

Examples of the qualitative factors in make-or-buy decision are: control over quality of the component, reliability of

suppliers and impact of the decision on suppliers and customers, etc.

The quantitative factors are actually the incremental costs resulting from making or buying the component. For example:

incremental production cost per unit, purchase cost per unit, production capacity available to manufacture the component,

etc.

The following example illustrates the numerical part of a simple make-or-buy decision.

Example

The estimated costs of producing 6,000 units of a component are:

Per Unit Total

Direct Material $10 $60,000

Direct Labor 8 48,000

Applied Variable Factory Overhead 9 54,000

Applied Fixed Factory Overhead 12 72,000

$1.5 per direct labor dollar

$39 $234,000

The same component can be purchased from market at a price of $29 per unit. If the component is purchased from market,

25% of the fixed factory overhead will be saved.

Should the component be purchased from the market?

Solution

Per Unit Total

Make Buy Make Buy

Purchase Price $29 $174,000

Direct Material $10 $60,000

Direct Labor 8 48,000

Variable Overhead 9 54,000

Relevant Fixed Overhead 3 18,000

Total Relevant Costs $30 $29 $180,000 $174,000

Difference in Favor of Buying $1 $6,000

Sell-or-Process-Further Decision

A decision whether to sell a joint product at split-off point or to process it further and sell it in a more refined form is called

a sell-or-process-further decision. Joint products are two or more products which have been manufactured from the same

inputs and in a same production process (i.e. a joint process). The point at which joint products leave the joint process is

called split-off point.

Some of the joint products may be in final form ready for sale, while others may be processed further. In such cases

managers have to decide whether to sell the unfinished goods at split-off point or to process them further. Such decision is

known as sell-or-process-further decision and it must be made so as to maximize the profits of the business.

A sell-or-process-further analysis can be carried out in three different ways:

Incremental (or Differential) Approach calculates the difference between the additional revenues and the

additional costs of further processing. If the difference is positive the product must be processed further,

otherwise not.

Opportunity Cost Approach calculates the difference between net revenue from further processed product and

the opportunity cost of not selling the product at split-off point. If the difference is positive, further processing will

increase profits.

Total Project Approach (or the comparative statement approach) compares the profit statements of both options

(i.e. selling or further processing) separately for each product. The option generating higher profit is chosen.

The following example illustrates the approaches to a sell-or-process-further decision:

Example

Product A and B are produced in a joint process. At split-off point, Product A is complete whereas product B can be process

further. The following additional information is available:

Product A B

Quantity in Units 5,000 10,000

Selling Price Per Unit:

At Split-Off $10 $2.5

If Processed Further

$5

Costs After Split-Off

$20,000

Perform sell-or-process-further analysis for product B.

Solution

Incremental Approach:

Incremental Revenue $25,000

Incremental Costs 20,000

Increase in Profits Due to Further Processing $5,000

Opportunity Cost Approach:

Sales in Case of Further Processing $50,000

Costs:

Additional Costs 20,000

Opportunity Cost of Not Selling at Split-Off 25,000

Gain on Further Processing $5,000

Total Project Approach:

Split-Off

Point

Further

Processed

Revenue $25,000 $50,000

Costs 0 20,000

Net Revenue $25,000 $30,000

Gain from Further Processing

$5,000

Decision to Add or Drop Product Line

A decision whether or not to continue an old product line or department, or to start a new one is called an add-or-drop

decision. An add-or-drop decision must be based only on relevant information.

Relevant information includes the revenues and costs which are directly related to a product line or department. Examples

of relevant information are sales revenue, direct costs, variable overhead and direct fixed overhead. Such decision must not

be based on irrelevant information such as allocated fixed overhead because allocated fixed overhead will not be

eliminated if the product line or department is dropped.

The following example illustrates an add-or-drop decision:

Example

A company has three products: Product A, Product B and Product C. Income statements of the three product lines for the

latest month are given below:

Product Line A B C

Sales $467,000 $314,000 $598,000

Variable Costs 241,000 169,000 321,000

Contribution Margin $226,000 $145,000 $277,000

Direct Fixed Costs 91,000 86,000 112,000

Allocated Fixed Costs 93,000 62,000 120,000

Net Income $42,000 $3,000 $45,000

Use the incremental approach to determine if Product B should be dropped.

Solution

By dropping Product B, the company will lose the sale revenue from the product line. The company will also obtain gains in

the form of avoided costs. But it can avoid only the variable costs and direct fixed costs of product B and not the allocated

fixed costs. Hence:

If Product B is Dropped

Gains:

Variable Costs Avoided $169,000

Direct Fixed Costs Avoided $86,000 $255,000

Less: Sales Revenue Lost

$314,000

Decrease in Net Income of the Company

$59,000

Scarce Resource Utilization Decision

Scarce resource utilization (or allocation) decision is a judgment regarding the best use of scarce resources so as to

maximize the total net income of a business. Scarcity of different resources puts constraints on the amount of product that

can be produced using those resources. For example, a business may have limited number of machine hours to utilize in

production. Scarce resource allocation decision is also called limiting factors decision.

When resources are abundant, products generating relatively higher contribution margin per unit are preferred because it

leads to highest net income. However when resources are scarce, a decision in this way is unlikely to maximize the profit.

Instead the allocation of a scarce resource to various products must be based on the contribution margin per unit of the

scarce resource from each product.

A simple scarce resource allocation decision involves the following steps:

1. Calculate the contribution margin per unit of the scarce resource from each product.

2. Rank the products in the order of decreasing contribution margin per unit of scarce resource.

3. Estimate the number of units of each product which can be sold.

4. Allocate scarce resource first to the product with highest contribution margin per unit of scarce resource, then to

the product with next highest contribution margin per unit of scarce resource.

A scarce resource decision can be better explained using an example.

Example

A company has 4,000 machine hours of plant capacity per month which are to be allocated to products A and B. The

following per unit figures relate to the products:

Product A B

Sale Price $300 $240

Costs:

Direct Material 100 70

Direct Labor 65 50

Variable Overhead 20 40

Fixed Overhead 15 30

Variable Operating Expenses 40 20

Total Costs $240 $210

Net Income $60 $30

Machine Hours Required 1.5 1.00

Assuming that the company can sell all its output, determine how many machine hours shall be allocated to each product.

Solution

Product A B

Sale Price $300 $240

Variable Cost 225 180

CM Per Unit $75 $60

Machine Hours Required 1.50 1.00

CM Per Machine Hour $50 $60

Since the company can sell all its output the best decision is to allocate all machine hours (i.e. scarce resource) to product B.

Capital Budgeting

Capital budgeting (or investment appraisal) is the process of determining the viability to long-term investments on purchase

or replacement of property plant and equipment, new product line or other projects.

Capital budgeting consists of various techniques used by managers such as:

1. Payback Period

2. Discounted Payback Period

3. Net Present Value

4. Accounting Rate of Return

5. Internal Rate of Return

6. Profitability Index

All of the above techniques are based on the comparison of cash inflows and outflow of a project however they are

substantially different in their approach.

A brief introduction to the above methods is given below:

Payback Period measures the time in which the initial cash flow is returned by the project. Cash flows are not

discounted. Lower payback period is preferred.

Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash inflows. Higher NPV is

preferred and an investment is only viable if its NPV is positive.

Accounting Rate of Return (ARR) is the profitability of the project calculated as projected total net income divided

by initial or average investment. Net income is not discounted.

Internal Rate of Return (IRR) is the discount rate at which net present value of the project becomes zero. Higher

IRR should be preferred.

Profitability Index (PI) is the ratio of present value of future cash flows of a project to initial investment required

for the project.

The above techniques are explained in detail in next pages.

Payback Period

Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash

inflows generated by the investment. It is one of the simplest investment appraisal techniques.

Formula

The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even

or uneven. In case they are even, the formula to calculate payback period is:

Payback Period =

Initial Investment

Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the

following formula for payback period:

Payback Period = A +

B

C

In the above formula,

A is the last period with a negative cumulative cash flow;

B is the absolute value of cumulative cash flow at the end of the period A;

C is the total cash flow during the period after A

Both of the above situations are applied in the following examples.

Decision Rule

Accept the project only if its payback period is LESS than the target payback period.

Examples

Example 1: Even Cash Flows

Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to

generate $25 million per year for 7 years. Calculate the payback period of the project.

Solution

Payback Period = Initial Investment Annual Cash Flow = $105M $25M = 4.2 years

Example 2: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50 million and is expected to generate

$10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate

the payback value of the project.

Solution

(cash flows in millions)

Cumulative

Cash Flow

Year Cash Flow

0 (50) (50)

1 10 (40)

2 13 (27)

3 16 (11)

4 19 8

5 22 30

Payback Period

= 3 + (|-$11M| $19M)

= 3 + ($11M $19M)

3 + 0.58

3.58 years

Advantages and Disadvantages

Advantages of payback period are:

1. Payback period is very simple to calculate.

2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are considered

more uncertain, payback period provides an indication of how certain the project cash inflows are.

3. For companies facing liquidity problems, it provides a good ranking of projects that would return money early.

Disadvantages of payback period are:

1. Payback period does not take into account the time value of money which is a serious drawback since it can lead to

wrong decisions. A variation of payback method that attempts to remove this drawback is called discounted

payback period method.

2. It does not take into account, the cash flows that occur after the payback period.

Discounted Payback Period

One of the major disadvantages of simple payback period is that it ignores the time value of money. To counter this

limitation, an alternative procedure called discounted payback period may be followed, which accounts for time value of

money by discounting the cash inflows of the project.

Formulas and Calculation Procedure

In discounted payback period we have to calculate the present value of each cash inflow taking the start of the first period

as zero point. For this purpose the management has to set a suitable discount rate. The discounted cash inflow for each

period is to be calculated using the formula:

Discounted Cash Inflow =

Actual Cash Inflow

(1 + i)

n

Where,

i is the discount rate;

n is the period to which the cash inflow relates.

Usually the above formula is split into two components which are actual cash inflow and present value factor ( i.e. 1 / ( 1 + i

)^n ). Thus discounted cash flow is the product of actual cash flow and present value factor.

The rest of the procedure is similar to the calculation of simple payback period except that we have to use the discounted

cash flows as calculated above instead of actual cash flows. The cumulative cash flow will be replaced by cumulative

discounted cash flow.

Discounted Payback Period = A + B

C

Where,

A = Last period with a negative discounted cumulative cash flow;

B = Absolute value of discounted cumulative cash flow at the end of the period A;

C = Discounted cash flow during the period after A.

Note: In the calculation of simple payback period, we could use an alternative formula for situations where all the cash

inflows were even. That formula won't be applicable here since it is extremely unlikely that discounted cash inflows will be

even.

The calculation method is illustrated in the example below.

Decision Rule

If the discounted payback period is less that the target period, accept the project. Otherwise reject.

Example

An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate the discounted payback

period of the investment if the discount rate is 11%.

Solution

Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by present

value factor. Create a cumulative discounted cash flow column.

Year

n

Cash Flow

CF

Present Value Factor

PV$1=1/(1+i)

n

Discounted Cash Flow

CFPV$1

Cumulative Discounted

Cash Flow

0 $ 2,324,000 1.0000 $ 2,324,000 $ 2,324,000

1 600,000 0.9009 540,541 1,783,459

2 600,000 0.8116 486,973 1,296,486

3 600,000 0.7312 438,715 857,771

4 600,000 0.6587 395,239 462,533

5 600,000 0.5935 356,071 106,462

6 600,000 0.5346 320,785 214,323

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 5.32 years

Advantages and Disadvantages

Advantage: Discounted payback period is more reliable than simple payback period since it accounts for time value of

money. It is interesting to note that if a project has negative net present value it won't pay back the initial investment.

Disadvantage: It ignores the cash inflows from project after the payback period.

Accounting Rate of Return (ARR)

Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the

average investment made in the project. ARR is used in investment appraisal.

Formula

Accounting Rate of Return is calculated using the following formula:

ARR =

Average Accounting Profit

Average Investment

Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the

project's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project

divided by 2. Another variation of ARR formula uses initial investment instead of average investment.

Decision Rule

Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually

exclusive projects, accept the one with highest ARR.

Examples

Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years.

Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap value of $10,500 at end

of the 6th year. Calculate its accounting rate of return assuming that there are no other expenses on the project.

Solution

Annual Depreciation = (Initial Investment Scrap Value) Useful Life in Years

Annual Depreciation = ($130,000 $10,500) 6 $19,917

Average Accounting Income = $32,000 $19,917 = $12,083

Accounting Rate of Return = $12,083 $130,000 9.3%

Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash flows and salvage values are in

thousands of dollars. Use the straight line depreciation method.

Project A:

Year 0 1 2 3

Cash Outflow -220

Cash Inflow 91 130 105

Salvage Value 10

Project B:

Year 0 1 2 3

Cash Outflow -198

Cash Inflow 87 110 84

Salvage Value 18

Solution

Project A:

Step 1: Annual Depreciation = (220 10) / 3 = 70

Step 2: Year 1 2 3

Cash Inflow 91 130 105

Salvage Value 10

Depreciation* -70 -70 -70

Accounting Income 21 60 45

Step 3: Average Accounting Income = (21 + 60 + 45) / 3 = 42

Step 4: Accounting Rate of Return = 42 / 220 = 19.1%

Project B:

Step 1: Annual Depreciation = (198 18) / 3 = 60

Step 2: Year 1 2 3

Cash Inflow 87 110 84

Salvage Value 18

Depreciation* -60 -60 -60

Accounting Income 27 50 42

Step 3: Average Accounting Income = (27 + 50 + 42) / 3 = 39.666

Step 4: Accounting Rate of Return = 39.666 / 198 20.0%

Since the ARR of the project B is higher, it is more favorable than the project A.

Advantages and Disadvantages

Advantages

1. Like payback period, this method of investment appraisal is easy to calculate.

2. It recognizes the profitability factor of investment.

Disadvantages

1. It ignores time value of money. Suppose, if we use ARR to compare two projects having equal initial investments.

The project which has higher annual income in the latter years of its useful life may rank higher than the one

having higher annual income in the beginning years, even if the present value of the income generated by the

latter project is higher.

2. It can be calculated in different ways. Thus there is problem of consistency.

3. It uses accounting income rather than cash flow information. Thus it is not suitable for projects which having high

maintenance costs because their viability also depends upon timely cash inflows.

Net Present Value (NPV)

Net present value is the present value of net cash inflows generated by a project including salvage value, if any, less the

initial investment on the project. It is one of the most reliable measures used in capital budgeting because it accounts for

time value of money by using discounted cash inflows.

Before calculating NPV, a target rate of return is set which is used to discount the net cash inflows from a project. Net cash

inflow equals total cash inflow during a period less the expenses directly incurred on generating the cash inflow.

Calculation Methods and Formulas

The first step involved in the calculation of NPV is the determination of the present value of net cash inflows from a project

or asset. The net cash flows may be even (i.e. equal cash inflows in different periods) or uneven (i.e. different cash flows in

different periods). When they are even, present value can be easily calculated by using the present value formula of

annuity. However, if they are uneven, we need to calculate the present value of each individual net cash inflow separately.

In the second step we subtract the initial investment on the project from the total present value of inflows to arrive at net

present value.

Thus we have the following two formulas for the calculation of NPV:

When cash inflows are even:

NPV = R

1 (1 + i)

-n

Initial Investment

i

In the above formula,

R is the net cash inflow expected to be received each period;

i is the required rate of return per period;

n are the number of periods during which the project is expected to operate and generate cash inflows.

When cash inflows are uneven:

NPV =

R

1

+

R

2

+

R

3

+ ...

Initial Investment

(1 + i)

1

(1 + i)

2

(1 + i)

3

Where,

i is the target rate of return per period;

R

1

is the net cash inflow during the first period;

R

2

is the net cash inflow during the second period;

R

3

is the net cash inflow during the third period, and so on ...

Decision Rule

Accept the project only if its NPV is positive or zero. Reject the project having negative NPV. While comparing two or more

exclusive projects having positive NPVs, accept the one with highest NPV.

Examples

Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an initial investment of $243,000

and it is expected to generate a cash inflow of $50,000 each month for 12 months. Assume that the salvage value of the

project is zero. The target rate of return is 12% per annum.

Solution

We have,

Initial Investment = $243,000

Net Cash Inflow per Period = $50,000

Number of Periods = 12

Discount Rate per Period = 12% 12 = 1%

Net Present Value

= $50,000 (1 (1 + 1%) ^-12) 1% $243,000

= $50,000 (1 1.01^-12) 0.01 $243,000

$50,000 (1 0.887449) 0.01 $243,000

$50,000 0.112551 0.01 $243,000

$50,000 11.2551 $243,000

$562,754 $243,000

$319,754

Example 2: Uneven Cash Inflows: An initial investment on plant and machinery of $8,320 thousand is expected to generate

cash inflows of $3,411 thousand, $4,070 thousand, $5,824 thousand and $2,065 thousand at the end of first, second, third

and fourth year respectively. At the end of the fourth year, the machinery will be sold for $900 thousand. Calculate the

present value of the investment if the discount rate is 18%. Round your answer to nearest thousand dollars

Solution

PV Factors:

Year 1 = 1 (1 + 18%)^1 0.8475

Year 2 = 1 (1 + 18%)^2 0.7182

Year 3 = 1 (1 + 18%)^3 0.6086

Year 4 = 1 (1 + 18%)^4 0.5158

The rest of the problem can be solved more efficiently in table format as shown below:

Year 1 2 3 4

Net Cash Inflow $3,411 $4,070 $5,824 $2,065

Salvage Value

900

Total Cash Inflow $3,411 $4,070 $5,824 $2,965

Present Value Factor 0.8475 0.7182 0.6086 0.5158

Present Value of Cash Flows $2,890.68 $2,923.01 $3,544.67 $1,529.31

Total PV of Cash Inflows $10,888

Initial Investment 8,320

Net Present Value $2,568 thousand

Advantage and Disadvantage of NPV

Advantage: Net present value accounts for time value of money. Thus it is more reliable than other investment appraisal

techniques which do not discount future cash flows such payback period and accounting rate of return.

Disadvantage: It is based on estimated future cash flows of the project and estimates may be far from actual results.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero. In other

words, IRR is the discount rate which equates the present value of the future cash flows of an investment with the initial

investment. It is one of the several measures used for investment appraisal.

Decision Rule

A project should only be accepted if its IRR is NOT less than the target internal rate of return. When comparing two or more

mutually exclusive projects, the project having highest value of IRR should be accepted.

IRR Calculation

The calculation of IRR is a bit complex than other capital budgeting techniques. We know that at IRR, Net Present Value

(NPV) is zero, thus:

NPV = 0; or

PV of future cash flows Initial Investment = 0; or

CF

1

+

CF

2

+

CF

3

+ ... Initial Investment = 0

( 1 + r )

1

( 1 + r )

2

( 1 + r )

3

Where,

r is the internal rate of return;

CF

1

is the period one net cash inflow;

CF

2

is the period two net cash inflow,

CF

3

is the period three net cash inflow, and so on ...

But the problem is, we cannot isolate the variable r (=internal rate of return) on one side of the above equation. However,

there are alternative procedures which can be followed to find IRR. The simplest of them is described below:

1. Guess the value of r and calculate the NPV of the project at that value.

2. If NPV is close to zero then IRR is equal to r.

3. If NPV is greater than 0 then increase r and jump to step 5.

4. If NPV is smaller than 0 then decrease r and jump to step 5.

5. Recalculate NPV using the new value of r and go back to step 2.

Example

Find the IRR of an investment having initial cash outflow of $213,000. The cash inflows during the first, second, third and

fourth years are expected to be $65,200, $96,000, $73,100 and $55,400 respectively.

Solution

Assume that r is 10%.

NPV at 10% discount rate = $18,372

Since NPV is greater than zero we have to increase discount rate, thus

NPV at 13% discount rate = $4,521

But it is still greater than zero we have to further increase the discount rate, thus

NPV at 14% discount rate = $204

NPV at 15% discount rate = ($3,975)

Since NPV is fairly close to zero at 14% value of r, therefore

IRR 14%

Profitability Index

Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a

project by the initial investment required for the project.

Formula:

Profitability Index

=

Present Value of Future Cash Flows

Initial Investment Required

= 1 +

Net Present Value

Initial Investment Required

Explanation:

Profitability index is actually a modification of the net present value method. While present value is an absolute measure

(i.e. it gives as the total dollar figure for a project), the profitability index is a relative measure (i.e. it gives as the figure as a

ratio).

Decision Rule

Accept a project if the profitability index is greater than 1, stay indifferent if the profitability index is zero and don't accept a

project if the profitability index is below 1.

Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it helps in ranking

projects based on their per dollar return.

Example

Company C is undertaking a project at a cost of $50 million which is expected to generate future net cash flows with a

present value of $65 million. Calculate the profitability index.

Solution

Profitability Index = PV of Future Net Cash Flows / Initial Investment Required

Profitability Index = $65M / $50M = 1.3

Net Present Value = PV of Net Future Cash Flows Initial Investment Required

Net Present Value = $65M-$50M = $15M.

The information about NPV and initial investment can be used to calculate profitability index as follows:

Profitability Index = 1 + (Net Present Value / Initial Investment Required)

Profitability Index = 1 + $15M/$50M = 1.3

Adjusted Present Value

Adjusted present value is an investment appraisal technique similar to net present value method. However, instead of using

weighted average cost of capital as the discount rate, un-geared cost of equity is used to discount the cash flows from a

project and there is an adjustment for the tax shield provided by related debt capital.

Formula

Adjusted Present Value =

PV of Cash Flows using Un-geared Cost of Equity

+ Present Value of Tax Shield

Where PV stands for 'present value' and un-geared cost of equity is the required rate of return for a firm that is financed by

equity. It is calculated using the following formula:

Un-geared Cost of Equity =

Risk Free Rate

+ Asset beta (Market Return Risk Free Return)

Since interest cost is allowable as tax deduction therefore, when calculating taxable income it provides tax savings (also

called tax shield).

Tax Savings = Tax Rate Interest Expense Related to the Project

Tax savings are discounted using gross cost of debt.

Example

A project costing $50 million is expected to generate after tax cash flows of $10 million a year forever. Risk free rate is 3%,

asset beta is 1.5, required return on market is 12%, cost of debt is 8%, annual interest costs related to project are $2 million

and tax rate is 40%. Calculate the adjusted present value of the project.

Solution

Adjusted Present Value = Present Value of Cash Flows + Present Value of Tax Savings

We need to find un-geared cost of equity which is 3% + 1.5*(12% 3%) = 16.5%. Using this rate the present value of cash

flows = $10 million/0.165 = $60.61 million. Initial investment is $50 million no net present value of future cash flows using

un-geared cost of equity is $10.61 million ($60.61 million-$50 million).

Present value of tax savings = $2 million 0.4 / 0.08 = $10 million

Adjusted present value = present value of cash flows + present value of tax savings = $10.61 million + $10 million = $20.61

million.

Decision Rule

The decision rule for adjusted present value is the same as net present value: accept positive APV projects and reject

negative APV projects. The project discussed in the example has an APV of $20.61 which is positive hence the company

should undertake the project.

Master Budget

A master budget is a set of interconnected budgets of sales, production costs, purchases, incomes, etc. and it also includes

pro forma financial statements. A budget is a plan of future financial transactions. A master budget serves as planning and

control tool to the management since they can plan the business activities during the period on the basis of master budget.

At the end of each period, actual results can be compared with the master budget and necessary control actions can be

taken.

Components of Master Budget

Master budget has two major sections which are the operational budget and the financial budget. They have following

components:

Operational Budget

1. Sales Budget

2. Production Budget

3. Direct Material Purchases Budget

4. Direct Labor Budget

5. Overhead Budget

6. Selling and Administrative Expenses Budget

7. Cost of Goods Manufactured Budget

Financial Budget

1. Schedule of Expected Cash Receipts from Customers

2. Schedule of Expected Cash Payments to Suppliers

3. Cash Budget

4. Budgeted Income Statement

5. Budgeted Balance Sheet

Note that all of the above component budgets may not be included in the master budget of every business. Some of these

such as production budget and cost of goods manufactured budget are not need by a non-manufacturing business.

Order of components of master budget

As we said earlier, the components of master budget are interconnected, which means that numbers from one component

budget flow to another one. For example sales budget numbers are used in schedule of cash receipts from customers and

unless the sales budget is prepared we are unable to prepare schedule of receipts from customers because of lack of

information. This means that components of master budget must be prepared in a specific order. We have ordered the

above list in such a way that the necessary information needed by any component budget is provided by a preceding

component.

Sales Budget

Sales budget is the first and basic component of master budget and it shows the expected number of sales units of a period

and the expected price per unit. It also shows total sales which are simply the product of expected sales units and expected

price per unit.

Sales Budget influences many of the other components of master budget either directly or indirectly. This is due to the

reason that the total sales figure provided by sales budget is used as a base figure in other component budgets. For

example the schedule of receipts from customers, the production budget, pro forma income statement, etc.

Due to the fact that many components of master budget rely on sales budget, the estimated sales volume and price must

be forecasted with sufficient care and only reliable forecast techniques should be employed. Otherwise the master budget

will be rendered ineffective for planning and control.

Format and Example

Where the price per unit is expected to remain constant during the period for all units in sales, the sales budget format will

be simple as shown below.

Company A

Sales Budget

For the Year Ending December 30, 2010

Quarter

1 2 3 4 Year

Sales Units 1,320 954 1,103 1,766 5,143

Price per Unit $91 $92 $97 $112

Total Sales $120,120 $87,768 $106,991 $197,792 $512,671

However if a business sells more than one product having different prices or the price per unit is expected to change during

the period, its sales budget will be detailed.

Schedule of Expected Cash Collections

Schedule of expected cash collections from customers shows the budgeted cash collections on sales during a period. It is a

component of master budget and it is prepared after the preparation of sales budget and before the preparation of cash

budget.

The calculation of expected cash collections is based on the total sales figure obtained from sales budget. The management

estimates the proportion in which sales are expected to be collected in the current and following periods. This is used to

determine how much sales are expected to be collected during a period.

Format and Example

The master budget of Company A continues here with the preparation of schedule of expected cash collections. The sales

figures are obtained from the sales budget of the company. 70% of sales are expected to be collected in the quarter in

which sales are made and the rest are expected to be collected in the next period. Bad debts are negligible.

a) Q1 Sales = $120,120

Collections in Q1 = $120,120 70% = $84,084; Collections in Q2 = $120,120 30% = $36,036

b) Q2 Sales = $87,768

Collections in Q2 = $87,768 70% = $61,438; Collections in Q3 = $87,768 30% = $26,330

c) Q3 Sales = $106,991

Collections in Q3 = $106,991 70% = $74,894; Collections in Q4 = $106,991 30% = $32,097

d) Q4 Sales = $197,792

Collections in Q4 = $197,792 70% = $138,454

Company A

Schedule of Expected Cash Collections

For the Year Ending December 30, 2010

Quarter

1 2 3 4 Year

Beginning AR $62,130 $62,130

Quarter 1 Sales (a) 84,084 $36,036 120,120

Quarter 2 Sales (b) 61,438 $26,330 87,768

Quarter 3 Sales (c) 74,894 $32,097 106,991

Quarter 4 Sales (d) 138,454 138,454

Total Collections $146,214 $97,474 $101,224 $170,551 $515,463

Production Budget

Production budget is a schedule showing planned production in units which must be made by a manufacturer during a

specific period to meet the expected demand for sales and the planned finished goods inventory. The required production

is determined by subtracting the beginning finished goods inventory from the sum of expected sales and planned ending

inventory of the period. Thus:

Planned Production in Units

= Expected Sales in Units

+ Planned Ending Inventory in Units

Beginning Inventory in Units

Production budget is prepared after sales budget since it needs the expected sales units figure which is provided by the

sales budget. It is important to note that only a manufacturing business needs to prepare the production budget.

Format and Example

The following example illustrates the production budget format. The expected sales units are obtained from the sales

budget of Company A. The planned ending units of 1st, 2nd and 3rd period are the beginning units in 2nd, 3rd and 4th

period respectively.

Company A

Production Budget

For the Year Ending December 30, 2010

Quarter

1 2 3 4 Year

Budgeted Sales Units 1,320 954 1,103 1,766 5,143

+ Planned Ending Units 210 168 213 225 225

Beginning Units 196 210 168 213 196

Planned Production in Units 1,334 912 1,148 1,778 5,172

Direct Material Purchases Budget

Direct material purchases budget shows budgeted beginning and ending direct material inventory, the quantity of direct

material that will be used in production, the amount of direct material that must be purchased and its cost during a specific

period. Direct material purchases budget is a component of master budget and it is based on the following formula:

Budgeted Direct Material Purchases in Units = Budgeted Beginning Direct Material in Units + Direct Material in Units

Needed for Production Budgeted Ending Direct Material in Units

In the above formula, the direct material in units that is needed for production is calculated as follows:

Budgeted Production during the Period Units of Direct Material Required per Unit = Direct Material in Units needed for

Production

Since the budgeted production figure is provided by the production budget, the direct material purchases budget can be

prepared only after the preparation of production budget.

Format and Example

The following example shows the format of a simple direct material purchases budget. The budgeted production figures are

obtained from the production budget of Company A. Note that the budgeted ending direct material of 1st, 2nd and 3rd

period is the beginning direct material in 2nd, 3rd and 4th period respectively.

Company A

Direct Material Purchases Budget

For the Year Ending December 30, 2010

Quarter

1 2 3 4 Year

Budgeted Production in Units 1,334 912 1,148 1,778 5,172

DM Required per Unit (lb.) 4.00 4.00 4.00 4.00 4.00

DM Required of Production (lb.) 5,336 3,648 4,592 7,112 20,688

+ Budgeted Ending DM (lb.) 547 689 1,068 961 961

Beginning Direct Material (lb.) 800 547 689 1,068 800

Budgeted DM Purchases (lb.) 5,083 3,790 4,971 7,005 20,849

Cost per Pound $3.10 $3.20 $3.50 $4.00

Budgeted DM Purchases in $ $15,757 $12,128 $17,398 $28,020 $73,304

Schedule of Expected Cash Payments

Schedule of expected cash payments to suppliers shows the budgeted cash payments on purchases during a period. The

schedule of expected cash payments is a component of master budget and it is prepared after direct material purchases

budget but before cash budget.

The expected cash collections during a period is calculated on the basis of total purchases figure, that is obtained from

direct material purchases budget, and on the percentage / proportion in which purchases are to be paid for in the current

and following periods.

Format and Example

The following example shows the format of schedule of expected cash payments to suppliers. The purchases figures are

obtained from the direct material purchases budget of company A. The company expects to pay 80% of the purchases in

the period of purchase and 20% in following period.

a) Q1 Purchases = $15,757; Payments in Q1 = $15,757 80% = $12,606; Payments in Q2 = $15,757 20% = $3,151

b) Q2 Purchases = $12,128; Payments in Q2 = $12,128 80% = $9,702; Payments in Q3 = $12,128 20% = $2,426

c) Q3 Purchases = $17,398; Payments in Q3 = $17,398 80% = $13,918; Payments in Q4 = $17,398 20% = $3,480

d) Q4 Purchases = $28,060; Payments in Q4 = $28,060 80% = $22,448

Schedule of Expected Cash Payments

For the Year Ending December 30, 2010

Quarter

1 2 3 4 Year

Beginning AP $2,350 $2,350

Quarter 1 Purchases (a) 12,606 $3,151 15,757

Quarter 2 Purchases (b) 9,702 $2,426 12,128

Quarter 3 Purchases (c) 13,918 $3,480 17,398

Quarter 4 Purchases (d) 22,448 22,448

Total Expected Payments $14,956 $12,853 $16,344 $25,928 $70,081

Direct Labor Budget

Direct labor budget shows the total direct labor cost and number of direct labor hours needed for production. It helps the

management to plan its labor force requirements. Direct labor budget is a component of master budget. It is prepared after

the preparation of production budget because the budgeted production in units figure provided by the production budget

serves as starting point in direct labor budget. Following are the calculations involved in the direct labor budget:

Planned Production in units Direct Labor Hours Required per Unit= Budgeted Direct Labor Hours Required Cost per

Direct Labor Hours= Budgeted Direct Labor Cost

Format and Example

Following is an example showing a simple direct labor budget format. The planned production figures are obtained from the

production budget of Company A.

Direct Material Purchases Budget

For the Year Ending December 30, 2010

Quarter

1 2 3 4 Year

Planned Production in Units 1,334 912 1,148 1,778 5,172

Direct Labor Hours per Unit 3.5 3.5 3.5 3.5 3.5

Budgeted Direct Labor Hours 4,669 3,192 4,018 6,223 18,102

Cost per Direct Labor Hour $4 $5 $5 $5

Budgeted Direct Labor Cost $18,676 $15,960 $20,090 $31,115 $85,841

Factory Overhead Budget

The factory overhead budget shows all the planned manufacturing costs which are needed to produce the budgeted

production level of a period, other than direct costs which are already covered under direct material budget and direct

labor budget. The overhead budget is an operational budget contained in the master budget of a business. It has two

sections, one for variable overhead costs and other for fixed overhead costs.

Total variable overhead may be calculated as the product of estimated variable cost per unit (also called variable overhead

rate) and the budgeted production units (obtained from production budget). However most businesses will prefer to

prepare a detailed overhead budget showing individual variable costs such as electricity, fuel, supplies etc.. The fixed

overhead costs are calculated as the sum of individual fixed overhead costs for example rent, depreciation, etc. which are

planned for the period.

It is also useful to calculate the expected cash disbursements for factory overhead costs at the end of overhead budget.

Format and Example

The following example illustrates the format of a simple overhead budget. The variable overhead per unit of Company A

during the first, second, third and fourth quarter is estimated to be $12, $15, $16 and $19 respectively. The production unit

figures are obtained from the production budget of the company. The company expects to incur monthly depreciation of

$3,000 and monthly rent of $2,500. There are no other fixed costs.

Company A

Factory Overhead Budget

For the Year Ending December 30, 2010

Quarter

1 2 3 4 Year

Variable Factory Overhead:

Budgeted Production Units 1,334 912 1,148 1,778 5,172

Variable Overhead Rate $12 $15 $16 $19

Total Variable Overhead $16,008 $13,680 $18,368 $33,782 $81,838

Fixed Factory Overhead:

Depreciation 9,000 9,000 9,000 9,000 36,000

Rent 7,500 7,500 7,500 7,500 30,000

Total Fixed Overhead $16,500 $16,500 $16,500 $16,500 $66,000

Total Factory Overhead $32,508 $30,180 $34,868 $50,282 $147,838

Depreciation 9,000 9,000 9,000 9,000 36,000

Cash Disbursements for FOH $23,508 $21,180 $25,868 $41,282 $111,838

Selling and Administrative Expense Budget

Selling and administrative expense budget is a schedule of planned operating expenses other than manufacturing costs. It is

a component of master budget and it is prepared by all types of businesses (i.e. manufacturers, retailers and service

providers) before the preparation of budgeted income statement. Usually it is divided in two sections: the selling expenses

and the administrative expenses.

Both selling expenses and administrative expense may be fixed or variable (see cost behavior). For example sales

commission and freight cost on sales are variable selling expenses where as sales salaries are fixed selling expenses.

Similarly depreciation and rent on office building are fixed administrative expenses whereas office supplies and utilities

expense are variable administrative expenses.

Different variable selling and administrative expenses vary with different types activities. For example sales commission

vary with number of units sold, entertainment expenses with number of employees in the organization etc., therefore an

accurate selling and administrative expenses budget can be made by using activity based costing.

Format and Example

The following example illustrates the format of a typical selling and administrative expense budget:

Selling and Administrative Expense Budget

For the Year Ending December 30, 2010

Quarter

1 2 3 4 Year

Budgeted Selling Expenses:

Sales Commission $2,620 $2,380 $2,410 $3,590 $11,000

Freight-out 3,890 3,510 3,050 5,030 15,480

Budgeted Admin. Expenses:

Office Rent 8,000 8,000 8,000 8,000 32,000

Office Salaries 10,000 10,000 10,000 10,000 40,000

Office Supplies 1,120 1,030 1,560 2,370 6,080

Miscellaneous Expenses 700 700 700 700 2,800

Total Selling & Admin. Expense $26,330 $25,620 $25,720 $29,690 $107,360

Cost of Goods Manufactured Budget

Cost of goods manufactured budget is an operational component of master budget. It is prepared to calculate the

manufacturing costs that are expected to be incurred on budgeted finished goods. The cost of goods manufactured budget

is based on direct material purchases budget, direct labor cost budget and factory overhead budget.

The figures from direct labor budget and overhead budget are directly used in the preparation of cost of goods

manufactured budget but the direct material purchase cost needs to be adjusted as shown below:

Direct Material Purchases+ Direct Material Beginning Inventory Direct Material Ending Inventory

= Cost of Direct Material Used in Production

The next step is to calculate the budgeted cost of goods manufactured as follows:

Cost of Direct Material used in Production

+ Direct Labor Cost+ Factory Overhead Cost= Manufacturing Cost+ Beginning Work in Process Ending Work in Process

= Cost of Goods Manufactured

Format and Example

The format of cost of goods manufactured budget is shown in the following example. For the sake simplicity, we have

assumed zero work in process at the beginning and at the end of the periods.

Company A

Cost of Goods Manufactured Budget

For the Year Ending December 30, 2010

Quarter

1 2 3 4 Year

Direct Material Purchases $15,757 $12,128 $17,398 $28,020 $73,304

Beginning Direct Material 2,400 1,696 2,205 3,738 2,400

Ending Direct Material 1,696 2,205 3,738 3,844 3,844

Direct Material Cost $16,461 $11,619 $15,865 $27,914 $71,860

Direct Labor Cost 18,676 15,960 20,090 31,115 85,841

Manufacturing Overhead 23,508 21,180 25,868 41,282 111,838

Total Manufacturing Costs $58,645 $48,759 $61,823 $100,311 $269,539

Beginning Work in Process 0 0 0 0 0

Ending Work in Process 0 0 0 0 0

Budgeted Cost of Goods

Manufactured

$58,645 $48,759 $61,823 $100,311 $269,539

Cash Budget

Cash budget is a financial budget prepared to calculate the budgeted cash inflows and outflows during a period and the

budgeted cash balance at the end of the period. Cash budget helps the managers to determine any excessive idle cash or

cash shortage that is expected during the period. Such information helps the managers to plan accordingly. For example if

any cash shortage in expected in future, the managers plan to change the credit policy or to borrow money and if excessive

idle cash is expected, they plan to invest it or to use it for the repayment of loan.

All businesses need to maintain a safe level of cash to enable them to carry on business activities. The managers of a

business need to determine that safe level. The cash budget is then prepared by taking into consideration, that safe level of

Cash. Thus, if a cash shortage is expected during a period, a plan is made to borrow cash.

Cash budget is a component of master budget and it is based on the following components of master budget:

Schedule of expected cash collections

Schedule of expected cash payments

selling and administrative expense budget

Format and Example

The following example illustrates the format of cash budget. Company A maintains a minimum cash balance of $5,000. In

case of a deficiency, loan is obtained at 8% annual interest rate on the first day of the period.

Company A

Cash Budget

For the Year Ending December 30, 2010

Quarter

1 2 3 4 Year

Beginning Cash Balance $5,200 $5,000 $5,000 $11,740 $5,200

Add: Budgeted Cash Receipts: 37,150 54,190 53,730 62,300 207,370

Total Cash Available for Use $42,350 $59,190 $58,730 $74,040 $212,570

Less: Cash Disbursements

Direct Material 14,960 16,550 16,810 19,410 67,730

Direct Labor 8,830 9,610 9,750 11,900 40,090

Factory Overhead 10,020 10,400 11,000 11,780 43,200

Selling and Admin. Expenses 7,640 8,360 8,500 9,610 34,110

Equipment Purchases 6,000 14,000 20,000

Total Disbursements $41,450 $50,920 $46,060 $66,700 $205,130

Cash Surplus/(Deficit) $900 $8,270 $12,670 $7,340 $7,440

Financing:

Borrowing 4,100 4,000

Repayments 3,188 912 4,000

Interest 82 18 100

Net Cash from Financing $4,100 $3,270 $930 100

Budgeted Ending Cash Balance $5,000 $5,000 $11,740 $7,340 $7,340

Inventory Management

Inventory management deals with when to order and how much to order. It aims to minimize the total cost of inventories

so as to generate high return.

If we hold more than the optimum level of inventory, we are incurring considerable opportunity cost because the funds are

tied up in inventories. There are other explicit costs of holding inventory such as storage costs, insurance costs, etc. If we

hold too little inventory we might have to place more orders and incur more communication and transportation costs. Then

is another category of inventory costs: the stock out of costs. If we are too low inventories we might run out of stock and

might not be able to lose sales and customers.

We have some tools to minimize the above mentioned costs. These include:

Economic order quantity model

Just-in-time system

Traditionally companies would keep high level of inventories in accordance with the just-in-case system .They would keep

high inventories just in case they are faced with high demand. Such risk-averse companies intended to keep ordering costs

and stock out costs low. In JIT system on the other hand companies try not to keep inventories in hand and order only when

a sales order is received. Such a system is called pull system because inventories are pulled through the system by sales

order received.

Economic Order Quantity (EOQ)

Economic order quantity (EOQ) is the order quantity of inventory that minimizes the total cost of inventory management.

Two most important categories of inventory costs are ordering costs and carrying costs. Ordering costs are costs that are

incurred on obtaining additional inventories. They include costs incurred on communicating the order, transportation cost,

etc. Carrying costs represent the costs incurred on holding inventory in hand. They include the opportunity cost of money

held up in inventories, storage costs, spoilage costs, etc.

Ordering costs and carrying costs are quite opposite to each other. If we need to minimize carrying costs we have to place

small order which increases the ordering costs. If we want minimize our ordering costs we have to place few orders in a

year and this requires placing large orders which in turn increases the total carrying costs for the period.

We need to minimize the total inventory costs and EOQ model helps us just do that.

Total inventory costs = Ordering costs + Holding costs

By taking the first derivative of the function we find the following equation for minimum cost

EOQ = SQRT(2 Quantity Cost Per Order / Carrying Cost Per Order)

Example

ABC Ltd. is engaged in sale of footballs. Its cost per order is $400 and its carrying cost unit is $10 per unit per annum. The

company has a demand for 20,000 units per year. Calculate the order size, total orders required during a year, total carrying

cost and total ordering cost for the year.

Solution

EOQ = SQRT (2 20,000 400/10) = 1,265 units

Annual demand is 20,000 units so the company will have to place 16 orders (= annual demand of 20,000 divided by order

size of 1,265). Total ordering cost is hence $64,000 ($400 multiplied by 16).

Average inventory held is 632.5 ((0+1,265)/2) which means total carrying costs of $6,325 (i.e. 632.5 $10).

Reorder Level

Reorder level (or reorder point) is the inventory level at which a company would place a new order or start a new

manufacturing run.

Reorder Level = Lead Time in Days Daily Average Usage

Lead time is the time it takes the supplier or the manufacturing process to provide the ordered units.

Daily average usage is the number of units used each day.

If a business is holding a safety stock to act as buffer if daily usage accelerates the reorder level would increase by the l evel

of safety stock.

Reorder Level = Lead Time in Days Daily Average Usage + Safety Stock

Examples

Example 1: ABC Ltd. is a retailer of footwear. It sells 500 units of one of a famous brand daily. Its supplier takes a week to

deliver the order.

The inventory manager should place an order before the inventories drop below 3,500 units (500 units of daily usage

multiplied with 7 days of lead time) in order to avoid a stock-out.

Example 2: ABC Ltd. has decided to hold a safety stock equivalent to average usage of 5 days. Calculate the reorder level.

Safety stock which ABC Ltd. has decided to hold equals 2,500 units (500 units of daily usage multiplied by 5 days).

In this scenario reorder level would be 6,000 units (2,500 of safety stock plus 3,500 units based on 7 days of lead time).

Safety Stock

Safety stock is the stock held by a company in excess of its requirement for the lead time. Companies hold safety stock to

guard against stock-out.

Safety stock is calculated using the following formula:

Safety Stock = (Maximum Daily Usage Average Daily Usage) Lead Time

Lead time is the time which supplier takes in ordering the items

Example

ABC Ltd. is engaged in production of tires. It purchases rims from DEL Ltd. an external supplier. DEL Ltd. takes 10 days in

manufacturing and delivering an order. ABC's requires 10,000 units of rims. Its ordering cost is $1,000 per order and its

carrying costs are $3 per unit per year. The maximum usage per day could be 50 per day. Calculate economic order

quantity, reorder level and safety stock.

Solution

EOQ = SQRT (2 Annual Demand Ordering Cost Per Unit / Carrying Cost Per Unit)

Maximum daily usage is 50 units and average daily usage is 27.4 (10,000 annual demand 365 days).

Safety Stock = (50-27.4) 10 = 226 units.

Reorder Level = Safety Stock + Average Daily Usage Lead Time

Reorder Level = 226 units + 27.4 units 10 = 500 units.

Standard Costing and Variance Analysis

Standard costing is the establishment of cost standards for activities and their periodic analysis to determine the reasons

for any variances. Standard costing is a tool that helps management account in controlling costs.

For example, at the beginning of a year a company estimates that labor costs should be $2 per unit. Such standards are

established either by historical trend analysis of the cost or by an estimation by any engineer or management scientist.

After a period, say one month, the company compares the actual cost incurred per unit, say $2.05 to the standard cost and

determines whether it has succeeded in controlling cost or not.

This comparison of actual costs with standard costs is called variance analysis and it is vital for controlling costs and

identifying ways for improving efficiency and profitability. If actual cost exceeds the standard costs, it is an unfavorable

variance. On the other hand, if actual cost is less than the standard cost, it is a favorable variance.

Variance analysis is usually conducted for

Direct material costs (price and quantity variances);

Direct labor costs (wage rate and efficiency variances); and

Overhead costs.

Analysis of variance in planned and actual sales and sales margin is also vital to ensure profitability.

Direct Material Price Variance

Direct material price variance (also called the direct material spending/rate variance) is the product of actual quantity of

direct material used and the difference between standard price and actual price per unit of direct material. It is calculated

using the following formula:

DM Price Variance = ( SP AP ) AQ

Where,

SP is the standard unit price of direct material

AP is the actual price per unit of direct material

AQ is the actual quantity of direct material used

Analysis

Direct material price variance is calculated to determine the efficiency of purchasing department in obtaining direct

material at low cost. A positive value of direct material price variance is favorable which means that direct material was

purchased for lesser amount than the standard price. A negative value of direct material price variance is unfavorable

because more than estimated price per unit is paid.

However, a favorable direct material price variance is not always good; it should be analyzed together with direct material

quantity variance. It is quite possible that the purchasing department may purchase low quality raw material to generate a

favorable direct material price variance. Such a favorable material price variance will be offset by an unfavorable direct

material quantity variance due to wastage of low quality direct material.

Example

Calculate the direct material price variance if the standard price and actual unit price per unit of direct material are $4.00

and $4.10 respectively; and actual units of direct material used during the period are 1,200. Determine whether the

variance is favorable or unfavorable.

Standard Price $ 4.00

Actual Price 4.10

Difference Per Unit 0.10

Actual Quantity 1,200

Direct Material Price Variance $ 120

Since the price paid by the company for the purchase of direct material is more than the standard price by $120, the DM

price variance is unfavorable.

Direct Material Quantity Variance

Direct material quantity variance (also called the direct material usage/efficiency variance) is the product of standard price

of a unit of direct material and the difference between standard quantity of direct material allowed and actual quantity of

direct material used. The formula to calculate direct material quantity variance is:

DM Quantity Variance = ( SQ AQ ) SP

Where,

SQ is the standard quantity allowed

AQ is the actual quantity of direct material used

SP is the standard price per unit of direct material

Standard quantity allowed (SQ) is calculated as the product of standard quantity of direct material per unit and actual units

produced.

Analysis

Direct material quantity variance is calculated to determine the efficiency of production department in converting raw

material to finished goods. In order to improve efficiency, wastage of raw material must be reduced. A negative value of

direct material quantity variance is unfavorable and it implies that more quantity of direct material has been used in the

production process than actually needed. A positive value of direct material quantity variance is favorable implying that raw

material was efficiently converted to finished goods.

Example

Use the following information to calculate direct material quantity variance. Also specify whether the variance is favorable

or unfavorable.

Standard Price of a Unit of Direct Material $ 4

Standard Quantity of Direct Material Per Unit 2

Actual Units Produced During the Period 620

Actual Quantity Used During the Period 1,200

Solution

Actual Units Produced 620

Standard Quantity of Direct Material Per Unit 2

Standard Quantity Allowed 1,240

Standard Quantity Allowed 1,240

Actual Quantity 1,200

Difference 40

Standard Price of a Unit of Direct Material $ 4

Direct Material Quantity Variance $ 160

In this case the production department performed efficiently and saved 40 units of direct material. Multiplying this by

standard price per unit yields a favorable direct material quantity variance of $160.

Direct Material Mix Variance

Direct material mix variance is the product of the standard price per unit of direct material and the difference between

standard mix quantity and actual quantity of direct material used. Standard mix quantity is the quantity of a particular

direct material which, if mixed with one of more different materials in a standard ratio, would have been consumed on the

actual quantity of a product produced. Direct material mix variance can be calculated only for a product having two or more

input materials. The formula is:

DM Mix Variance = ( SM AQ ) SP

Where,

SM is the standard mix quantity of direct material

AQ is the actual quantity of material used

SP is the standard price per unit of direct material used

Standard mix quantity is calculated by multiplying standard mix percentage of a given material by total actual quantity of

the material used. For example, if three materials A, B and C are mixed in ratio 5:3:2 and actual quantity of material used is

2.5 kg then,

Standard mix quantity of material A = 2.5 5 / (5 + 3 + 2) = 2.5 50% = 1.25 kg

A positive value of DM mix variance is favorable whereas as a negative value is unfavorable.

Example

A product T is produced by mixing three materials: P, Q and R in a standard mix ratio of 1:2:2. Actual materials consumed

during the month ended May 31, 20X2 were 4,670g, 8,450g and 8,390g respectively. Standard prices are $0.04/g $0.03/g

and $0.02/g per gram respectively. Calculate the direct material mix variance.

Solution

Total Actual Quantity = 4,670 + 8,450 + 8,390g = 21,510g

Material P's Standard Mix % = 1 (1 + 2 + 2) = 0.2

Material Q's Standard Mix % = 2 (1 + 2 + 2) = 0.4

Material R's Standard Mix % = 2 (1 + 2 + 2) = 0.4

Material P Q R

Total Actual Quantity (g) 21,510 21,510 21,510

Standard Mix % 0.2 0.4 0.4

Standard Mix Quantity (g) 4,302 8,604 8,604

Actual Quantity (g) 4,670 8,450 8,390

Difference (g) -368 154 214

Standard Price ($/g) 0.04 0.03 0.02

Individual Material Mix Variance ($) 14.72 4.62 4.28

Total DM Mix Variance ($) 5.82

Direct Material Yield Variance

Direct material yield variance is the product of the standard price per unit of direct material and the difference between

standard quantity of direct material allowed for actual production and the standard mix quantity of direct material.

Standard mix quantity is the total quantity of two or more types of direct materials which, if mixed in the standard ratio,

would have been consumed on the actual quantity of the product produced. Direct material yield variance can be

calculated only for a product made from two or more direct materials. The formula is:

DM Yield Variance = ( SQ SM ) SP

Where,

SQ is the standard quantity of direct material

SM is the standard mix quantity of material used

SP is the standard price per unit of direct material used

Standard mix quantity is calculated by multiplying standard mix percentage of a given material by total actual quantity of

the material used. For example, if three materials A, B and C are mixed in ratio 5:3:2 and actual quantity of material used is

2.5 kg then,

Standard mix quantity of material A = 2.5 5 / (5 + 3 + 2) = 2.5 50% = 1.25 kg

A positive value of DM mix variance is favorable whereas as a negative value is unfavorable.

Example

Using the same example which we used in calculating the direct material mix variance:

A product T is produced by mixing three materials: P, Q and R in a standard mix ratio of 1:2:2. Actual materials consumed

during the month ended May 31, 20X2 were 4,670g, 8,450g and 8,390g respectively. Standard prices are $0.04/g $0.03/g

and $0.02/g per gram respectively whereas standard quantities allowed are 4,310g, 8,620g and 8,620g respectively.

Calculate the direct material yield variance.

Solution

Total Actual Quantity = 4,670 + 8,450 + 8,390g = 21,510g

Material P's Standard Mix % = 1 (1 + 2 + 2) = 0.2

Material Q's Standard Mix % = 2 (1 + 2 + 2) = 0.4

Material R's Standard Mix % = 2 (1 + 2 + 2) = 0.4

Material P Q R

Total Actual Quantity (g) 21,510 21,510 21,510

Standard Mix % 0.2 0.4 0.4

Standard Mix Quantity (g) 4,302 8,604 8,604

Material P Q R

Standard Quantity (g) 4,310 8,620 8,620

Standard Mix Quantity (g) 4,302 8,604 8,604

Difference (g) 8 16 16

Standard Price ($/g) 0.04 0.03 0.02

Individual Material Yield Variance ($) 0.32 0.48 0.32

Total DM Yield Variance ($) 1.12

Direct Labor Rate Variance

Direct labor rate variance (also called direct labor price/spending variance or wage rate variance) is the product of actual

direct labor hours and the difference between the standard direct labor rate and actual direct labor rate. Direct labor rate

variance is similar to direct material price variance. The following formula is used to calculate direct labor rate variance:

DL Rate Variance = ( SR AR ) AH

Where,

SR is the standard direct labor rate

AR is the actual direct labor rate

AH are the actual direct labor hours

Analysis

Direct labor rate variance determines the performance of human resource department in negotiating lower wage rates with

employees and labor unions. A positive value of direct labor rate variance is achieved when standard direct labor rate

exceeds actual direct labor rate. Thus positive values of direct labor rate variance are favorable and negative values are

unfavorable.

However, a positive value of direct labor rate variance may not always be good. When low skilled workers are recruited at

lower wage rate, the direct labor rate variance will be favorable however, such workers will be inefficient and will generate

a poor direct labor efficiency variance. Direct labor rate variance must be analyzed in combination with direct labor

efficiency variance.

Example

Calculate the direct labor rate variance if standard direct labor rate and actual direct labor rate are $18.00 and $17.20

respectively and actual direct labor hours used during the period are 800. Is the variance favorable or unfavorable?

Solution

Standard Rate $ 18.00

Actual Rate 17.20

Difference Per Hour 0.80

Actual Hours 130

Direct Labor Rate Variance $104

Since the actual labor rate is lower than the standard rate, the variance is positive and thus favorable.

Direct Labor Efficiency Variance

Direct labor efficiency variance (also called direct labor quantity/usage variance) is the product of standard direct labor rate

and the difference between the standard direct labor hours allowed and actual direct labor hours used. The basic concept

of direct labor efficiency variance is similar to that of direct material quantity variance. The following formula is used to

calculate direct labor efficiency variance:

DL Efficiency Variance = ( SH AH ) SR

Where,

SH are the standard direct labor hours allowed

AH are the actual direct labor hours used

SR is the standard direct labor rate per hour

The standard direct labor hours allowed (SH) in the above formula is the product of standard direct labor hours per unit and

number of finished units actually produced.

Analysis

The purpose of calculating the direct labor efficiency variance is to measure the performance of production department in

utilizing the abilities of the workers. A positive value of direct labor efficiency variance is obtained when the standard direct

labor hours allowed exceeds the actual direct labor hours used. Thus a positive value is favorable. Negative value of direct

labor efficiency variance implies that more direct labor hours have been used than actually needed.

It is necessary to analyze direct labor efficiency variance along with direct labor rate variance. It is quite possible that

unfavorable direct labor efficiency variance is simply the result of recruiting low skilled workers. In which case direct labor

rate variance will become favorable at the expense of direct labor efficiency.

Example

Use the following information to calculate direct labor efficiency variance. State whether the variance is favorable or

unfavorable.

Standard Rate Per Hour of Direct Labor $ 18

Standard Direct Labor Hours Required Per Unit 0.2

Actual Units Produced During the Period 620

Actual Direct Labor Hours Used During the Period 130

Solution

Actual Units Produced 620

Standard Direct Labor Hours Per Unit 0.2

Standard Direct Labor Hours Allowed 124

Standard Direct Labor Hours Allowed 124

Actual Direct Labor Hours Used 130

Difference 6

Standard Direct Labor Rate $ 18

Direct Labor Efficiency Variance $ 108

Since the direct labor efficiency variance is negative, it is unfavorable.

Variable Overhead Spending Variance

Variable Overhead spending variance (also called variable overhead rate variance) is the product of actual units of the

allocation base of variable overhead and the difference between standard variable overhead rate and actual variable

overhead rate. The formula to calculate the variable overhead spending variance is:

VOH Spending Variance = ( SR AR ) AU

Where,

SR is the standard variable overhead rate

AR is the actual variable overhead rate

AU are the actual units of allocation base

The standard variable overhead rate is the same as variable overhead application rate. The allocation base is usually the

number of labor hours used. The above formula can also be stated alternatively as follows:

VOH Spending Variance = ( SR AU ) Actual Variable Overhead Cost

Analysis

A positive value of variable overhead rate is obtained when standard variable overhead application rate is more than actual

variable overhead rate whereas a negative value of variable overhead rate is obtained when actual variable overhead rate

exceeds standard variable overhead rate. Thus a positive value of variable overhead spending variance is favorable and a

negative value is unfavorable.

In case of a negative variable overhead spending variance, production department is usually responsible.

Example

Calculate variable overhead spending variance if actual labor hours used are 130, standard variable overhead rate is $9.40

per direct labor hour and actual variable overhead rate is $8.30 per direct labor hour. Also specify whether the variance is

favorable or unfavorable.

Solution

Standard Variable Overhead Rate $ 9.40

Actual Variable Overhead Rate 8.30

Difference Per Hour $ 1.10

Actual Labor Hours 130

Variable Overhead Spending Variance $143

The variable overhead variance calculated above is favorable.

Variable Overhead Efficiency Variance

Variable overhead efficiency variance is the product of standard variable overhead rate and the difference between the

standard units allowed of the variable overhead application base and actual units used of the variable overhead application

base. Assuming that variable overhead application base is direct labor hours, the formula to calculate variable overhead

efficiency variance will be:

VOH Efficiency Variance = ( SH AH ) SR

Where,

SH are standard direct labor hours allowed

AH are the actual direct labor hours

SR is the standard variable overhead rate

The standard direct labor hours allowed (SH) in the above formula is calculated by multiplying standard direct labor hours

per unit and actual units produced.

Analysis

As the name suggests, variable overhead efficiency variance measure the efficiency of production department in converting

inputs to outputs. Variable overhead efficiency variance is positive when standard hours allowed exceed actual hours.

Therefore a positive value is favorable implying that production process was carried out efficiently with minimal loss of

resources.

On the other hand when actual hours exceed standard hours allowed, the variance is negative and unfavorable implying

that production process was inefficient.

Example

Calculate the variable overhead efficiency variance using the following figures:

Number of Units Produced 620

Standard Direct Labor Hours Per Unit 0.2

Actual Direct Labor Hours Used 130

Standard Variable Overhead Rate $9.40

Solution

Actual Units Produced 620

Standard Direct Labor Hours Per Unit 0.2

Standard Direct Labor Hours Allowed 124

Standard Hours Allowed 124

Actual Hours Used 130

Difference 6

Standard Variable Overhead Rate $9.4

Direct Labor Efficiency Variance $56.4

The variance calculated above is negative and thus unfavorable.

Performance Measurement

A business normally has more than one segment which facilitates specialization in the specific area and results in increased

efficiency and profitability. For example, an airline may have segments like domestic operations, international operations,

freight operations, etc. while an automobile manufacturer may have segments like motor bikes, cars, trucks, SUVs, etc.

Segments are either cost center, revenue center, profit center or investment center depending on the nature of their

operations and the level of responsibility given to the segment management.

The central management provides the overall direction and strategy but a significant amount of decision making is

delegated to the segment management. It is important to actively monitor their performance which is measured by

management accounting tools such as residual income, return on investment, accounting rate of return, etc. By analyzing

these metrics, the centralized management decides whether to put in additional investment in a segment based on its

excellent performance or to divest from a segment when it is losing money.

These tools are also useful in comparing performance of different managers and in many businesses their remuneration is

linked to the ROI or residual income they earn.

Residual Income (RI)

In the context of management accounting, residual income is a metric used to measure performance of a department. It

measures the return earned by the department which is in excess of the minimum required return.

Formula

The formula to calculate residual income is:

Residual Income (RI) = A (B C)

In the above formula,

A = Department's net operating income;

B = Minimum required return on assets; and

C = Average operating assets of the department

Department's net operating income is the department's revenue minus all expenses for which the department manager is

responsible.

The minimum required return on assets is the opportunity cost of the funds for the company which means it is the

percentage return which the company expects to earn on alternate projects.

Average operating assets of the department represent the asset base of the department.

The main advantage of the residual income metric is that it measures excess return earned by a department in absolute

terms. A positive residual income means that the department has met the minimum return requirement while a negative

residual income means that the department has failed to meet it. Return on investment (ROI) is another metric which

measures return in relative terms.

Example

CP Inc. is a company engaged in production and distribution of computers and printers. It has two main operating

departments: department C specializes in design, production and marketing of computers and Department P deals in

printers.

Department C has earned net operating profit of $300 million for the FY 2011 while department P has earned operating

profit of $130 million for the same period. Department C had opening operating assets of $1 billion and its closing operating

assets are $1.1 billion while department P had opening operating assets of $0.5 billion while its closing operating assets are

$0.7 million.

The company's weighted average cost of capital is 12% and it can use all the assets on a new project that earns a return of

15%.

Solution

Since the company can earn 15% on alternate projects, it is treated as the minimum required return.

Department C's average operating assets are $1.05 billion on which the minimum required return is $157.5 million. Its

residual income is hence $142.5 million ($300 million minus $157.5 million).

Department P's average operating assets are $0.6 billion on which the minimum required return is $90 million. Its residual

income is hence $40 million ($130 million minus $90 million).

Department C has earned $142.5 million residual income as compared to $40 million earned by department P. Residual

income allows us to compare the dollar amount of residual income earned by different departments. Since the residual

income in both cases is positive, we conclude that both have met the minimum return requirements. However, with

residual income is not easy to compare performance.

Return on investment (ROI) calculates total return in percentage terms and is a better measure of relative performance. In

this example, department C has a return on investment (ROI) of 28.6% ($300 million/$1,050 million) while department P

has return on investment (ROI) of 18.6% ($130 million/$700 million).

Return on Investment (ROI)

In the context of management accounting, return on investment (ROI) is a metric used to measure performance of

departments in relative terms. It calculates departments' return on their average operating assets.

Formula

Return on investment is calculated using the following formula:

ROI =

Department's Net Operating Income

Average Operating Assets of the Department

Department's net operating income is the department's revenue minus all expenses for which the department manager is

responsible.

Average operating assets of the department represent the asset base of the department.

The main advantage of the return on investment (ROI) as a performance measurement metric is that it helps in comparing

performance of different departments with each other. Residual income is another performance measurement tool which

calculates excess return in absolute dollar terms.

Example

CP Inc. is a company engaged in production and distribution of computers and printers. It has two main operating

departments: department C specializes in design, production and marketing of computers and Department P deals in

printers.

Department C has earned net operating profit of $300 million for the FY 2011 while department P has earned operating

profit of $130 million for the same period. Department C had opening operating assets of $1 billion and its closing operating

assets are $1.1 billion while department P had opening operating assets of $0.5 billion while its closing operating assets are

$0.7 million.

CP Inc. has minimum return requirement of 12%.

Solution

Department C's average operating assets are $1.05 billion while department P's average operating assets are $0.6 billion.

Department C has a return on investment (ROI) of 28.6% ($300 million/$1,050 million) while department P has return on

investment (ROI) of 18.6% ($130 million/$700 million).

It tells that department C has performed better than department P. Since the minimum return is 12%, ROI also tells that

both the departments have met the minimum return requirement.

Time Value of Money (TVM)

Time value of money is the concept that the value of a dollar to be received in future is less than the value of a dollar on

hand today. One reason is that money received today can be invested thus generating more money. Another reason is that

when a person opts to receive a sum of money in future rather than today, he is effectively lending the money and there

are risks involved in lending such as default risk and inflation. Default risk arises when the borrower does not pay the

money back to the lender. Inflation is the rise in general level of prices.

Time value of money principle also applies when comparing the worth of money to be received in future and the worth of

money to be received in further future. In other words, TVM principle says that the value of given sum of money to be

received on a particular date is more than same sum of money to be received on a later date.

Few of the basic terms used in time value of money calculations are:

Present Value

When a future payment or series of payments are discounted at the given rate of interest up to the present date to reflect

the time value of money, the resulting value is called present value.

Read further: Present Value of a Single Sum of Money and Present Value of an Annuity

Future Value

Future value is amount that is obtained by enhancing the value of a present payment or a series of payments at the given

rate of interest to reflect the time value of money.

Read further: Future Value of a Single Sum of Money and Future Value of an Annuity

Interest

Interest is charge against use of money paid by the borrower to the lender in addition to the actual money lent.

Read further: Simple vs. Compound Interest

Application of Time Value of Money Principle

There are many applications of time value of money principle. For example, we can use it to compare the worth of cash

flows occurring at different times in future, to find the present worth of a series of payments to be received periodically i n

future, to find the required amount of current investment that must be made at a given interest rate to generate a required

future cash flow, etc.

Simple vs. Compound Interest Calculation

Interest is the charge against the use of money by the borrower. The same is profit earned by the lender of money. The

amount which is invested in a bank in order to earn interest is called principal. The interest rate is normally expressed in

percentage and represents the dollar interest earned per $100 of principal in a specific time, usually a year. Simple interest

and compound interest are the two types of interest based on the way they are calculated.

Simple Interest

Simple interest is charged only on the principal amount. The following formula can be used to calculate simple interest:

Simple Interest (I

s

) = P i t

Where,

P is the principle amount;

i is the interest rate per period;

t is the time for which the money is borrowed or lent.

Example 1

Suppose $1,000 were invested on January 1, 2010 at 10% simple interest rate for 5 years. Calculate the total simple interest

on the amount.

Solution

We have,

Principle P = $1,000

Interest Rate i = 10% per year

Time t = 5 years

Simple Interest I

s

= $1,000 0.1 5 = $500

Compound Interest

Compound interest is charged on the principal plus any interest accrued till the point of time at which interest is being

calculated. In other words, compound interest system works as follows:

1. Interest for the first period charged on principle amount.

2. For the second period, its charged on the sum of principle amount and interest charged during the first period.

3. For the third period, it is charged on the sum of principle amount and interest charged during first and second

period, and so on ...

It can be proved mathematically, that the interest calculated as per above procedure is given by the following formula:

Compound Interest (I

c

) = P (1 + i)

n

P

Where,

P is the principle amount;

i is the compound interest rate per period;

n are the number of periods.

Example 2

Consider the same information as given in Example 1. Now calculate the total compound interest on the amount invested.

Solution

We have,

Principle P = $1,000

Interest Rate i = 10% per year

No. of Periods n = 5

Compound Interest I

c

= $1,000 ( 1 + 0.1 )^5 $1,000

= $1,000 1.1^5 $1,000

= $1,000 1.61051 $1,000

= $1,610.51 $1,000 = $610.51

Present Value of a Single Sum of Money

Present value of a future single sum of money is the value that is obtained when the future value is discounted at a specific

given rate of interest. In the other words present value of a single sum of money is the amount that, if invested on a given

date at a specific rate of interest, will equate the sum of the amount invested and the compound interest earned on its

investment with the face value of the future single sum of money.

Formula

The formula to calculate present value of a future single sum of money is:

Present Value (PV) =

Future Value (FV)

(1 + i)

n

Where,

i is the interest rate per compounding period; and

n are the number of compounding periods.

Examples

Example 1: Calculate the present value on Jan 1, 2011 of $1,500 to be received on Dec 31, 2011. The market interest rate is

9%. Compounding is done on monthly basis.

Solution

We have,

Future Value FV = $1,500

Compounding Periods n = 12

Interest Rate i = 9%/12 = 0.75%

Present Value PV = $1,500 / ( 1 + 0.75% )^12

= $1,500 / 1.0075^12

$1,500 / 1.093807

$1,371.36

Example 2: A friend of you has won a prize of $10,000 to be paid exactly after 2 years. On the same day, he was offered

$8,000 as a consideration for his agreement to sell the right to receive the prize. The market interest rate is 12% and the

interest is compounded on monthly basis. Help him by determining whether the offer should be accepted or not.

Solution

Here you will compute the present value of the prize and compare it with the amount offered to your friend. It will be good

to accept the offer if the present value of the prize is less than the amount offered.

So,

Future Value FV = $10,000

Compounding Periods n = 2 12 = 24

Interest Rate i = 12%/12 = 1%

Present Value PV = $10,000 / ( 1 + 1% )^24

= $10,000 / 1.01^24

$10,000 / 1.269735

$7,875.66

Since the present value of the prize is less than the amount offered, it is good to accept the offer.

Present Value of an Annuity

An annuity is a series of evenly spaced equal payments made for a certain amount of time. There are two basic types of

annuity known as ordinary annuity and annuity due. Ordinary annuity is one in which periodic payments are made at the

end of each period. Annuity due is the one in which periodic payments are made at the beginning of each period.

The present value an annuity is the sum of the periodic payments each discounted at the given rate of interest to reflect the

time value of money. Alternatively defined, the present value of an annuity is the amount which if invested at the start of

first period at the given rate of interest will equate the sum of the amount invested and the compound interest earned on

the investment with the product of number of the periodic payments and the face value of each payment.

Formula

Although the present value (PV) of an annuity can be calculated by discounting each periodic payment separately to the

starting point and then adding up all the discounted figures, however, it is more convenient to use the 'one step' formulas

given below.

PV of an Ordinary Annuity = R

1 (1 + i)

-n

i

PV of an Annuity Due = R

1 (1 + i)

-n

(1 + i)

i

Where,

i is the interest rate per compounding period;

n are the number of compounding periods; and

R is the fixed periodic payment.

Examples

Example 1: Calculate the present value on Jan 1, 2011 of an annuity of $500 paid at the end of each month of the calendar

year 2011. The annual interest rate is 12%.

Solution

We have,

Periodic Payment R = $500

Number of Periods n = 12

Interest Rate i = 12%/12 = 1%

Present Value PV = $500 (1-(1+1%)^(-12))/1%

= $500 (1-1.01^-12)/1%

$500 (1-0.88745)/1%

$500 0.11255/1%

$500 11.255

$5,627.54

Example 2: A certain amount was invested on Jan 1, 2010 such that it generated a periodic payment of $1,000 at the

beginning of each month of the calendar year 2010. The interest rate on the investment was 13.2%. Calculate the original

investment and the interest earned.

Solution

Periodic Payment R = $1,000

Number of Periods n = 12

Interest Rate i = 13.2%/12 = 1.1%

Original Investment = PV of annuity due on Jan 1, 2010

= $1,000 (1-(1+1.1%)^(-12))/1.1% (1+1.1%)

= $1,000 (1-1.011^-12)/0.011 1.011

$1,000 (1-0.876973)/0.011 1.011

$1,000 0.123027/0.011 1.011

$1,000 11.184289 1.011

$11,307.32

Interest Earned $1,000 12 $11,307.32

$692.68

Present Value of Perpetuity

Perpetuity is an infinite series of periodic payments of equal face value. In other words, perpetuity is a situation where a

constant payment is to be made periodically for an infinite amount of time. It as an annuity having no end and that is why

the perpetuity is sometimes called as perpetual annuity.

Although the total face value of perpetuity is infinite and undeterminable, its present value is not. According to the time

value of money principle, the present value of perpetuity is the sum of the discounted value of each periodic payment of

the perpetuity. Present value of perpetuity is finite because the discounted value of far future payments of the perpetuity

reduces considerably and reaches close to zero.

Formula

The following formula is used to calculate the present value of perpetuity:

Present Value (PV) of Perpetuity =

A

r

Where,

A is the fixed periodic payment; and

r is the interest rate or discount rate per compounding period.

Examples

Example 1: Calculate the present value on Jan 1, 20X0 of a perpetuity paying $1,000 at the end of each month starting from

January 20X0. The monthly discount rate is 0.8%.

Solution

Periodic Payment A = $1,000

Discount Rate i = 0.8%

Present Value PV = $1,000 0.8%

= $125,000

Future Value of a Single Sum of Money

Future value of a present single sum of money is the amount that will be obtained in future if the present single sum of

money is invested on a given date at the given rate of interest. The future value is the sum of present value and the

compound interest.

Formula

The future value of a single sum of money is calculated by using the following formula.

Future Value (FV) = Present Value (PV) (1 + i)

n

Where,

i is the interest rate per compounding period; and

n are the number of compounding periods.

Examples

Example 1: An amount of $10,000 was invested on Jan 1, 2011 at annual interest rate of 8%. Calculate the value of the

investment on Dec 31, 2013. Compounding is done on quarterly basis.

Solution

We have,

Present Value PV = $10,000

Compounding Periods n = 3 4 = 12

Interest Rate i = 8%/4 = 2%

Future Value FV = $10,000 ( 1 + 2% )^12

= $10,000 1.02^12

$10,000 1.268242

$12,682.42

Example 2: An amount of $25,000 was invested on Jan 1, 2010 at annual interest rate of 10.8% compounded on quarterly

basis. On Jan 1, 2011 the terms or the agreement were changed such that compounding was to be done twice a month

from Jan 1, 2011. The interest rate remained the same. Calculate the total value of investment on Dec 31, 2011.

Solution

The problem can be easily solved in two steps:

STEP 1: Jan 1 - Dec 31, 2010

Present Value PV

1

= $25,000

Compounding Periods n = 4

Interest Rate i = 10.8%/4 = 2.7%

Future Value FV

1

= $25,000 ( 1 + 2.7% )^4

= $25,000 1.027^4

$25,000 1.112453

$27,811.33

STEP 1: Jan 1 - Dec 31, 2011

Present Value PV

2

= FV

1

= $27,811.33

Compounding Periods n = 2 12 = 24

Interest Rate i = 10.8%/24 = 0.45%

Future Value FV

2

= $27,811.33 ( 1 + 0.45% )^24

= $27,811.33 1.0045^24

$27,811.33 1.113778

$30.975.64

Future Value of an Annuity

The future value of an annuity is the value of its periodic payments each enhanced at a specific rate of interest for given

number of periods to reflect the time value of money. In other words, future value of an annuity is equal to the sum of face

value of periodic annuity payments and the total compound interest earned on all periodic payments till the future value

point.

Formula

There are two types of annuity. The one in which payments occur at the end of each period is called ordinary annuity and

the other in which payments occur at the beginning of each period is called annuity due. Both types have different formulas

for future value calculation:

FV of Ordinary Annuity = R (1 + i)

n

1

i

FV of Annuity Due = R

(1 + i)

n

1

(1 + i)

i

In the above formulas,

i is the interest rate per compounding period;

n are the number of compounding periods; and

R is the fixed periodic payment.

Examples

Example 1: Mr A deposited $700 at the end of each month of calendar year 2010 in an investment account of 9% annual

interest rate. Calculate the future value of the annuity on Dec 31, 2011. Compounding is done on monthly basis.

Solution

We have,

Periodic Payment R = $700

Number of Periods n = 12

Interest Rate i = 9%/12 = 0.75%

Future Value PV = $700 {(1+0.75%)^12-1}/1%

= $700 {1.0075^12-1}/0.01

$700 (1.0938069-1)/0.01

$700 0.0938069/0.01

$700 9.38069

$6,566.48

Example 2: Calculate the future value of 12 monthly deposits of $1,000 if each payment is made on the first day of the

month and the interest rate per month is 1.1%. Also calculate the total interest earned on the deposits if the whole amount

is withdrawn on the last day of 12th month.

Solution

Periodic Payment R = $1,000

Number of Periods n = 12

Interest Rate i = 1.1%

Future Value = $1,000 {(1+1.1%)^12-1}/1.1% (1+1.1%)

= $1,000 {1.011^12-1}/0.011 (1+0.011)

= $1,000 (1.140286-1)/0.011 1.011

$1,000 0.140286/0.011 1.011

$1,000 12.75329059 1.011

$12,893.58

Interest Earned $12,893.58 - $1,000 12

$893.58

Beta Coefficient

Beta coefficient is a measure of sensitivity of a share price to movement in the market price. It measures systematic risk

which is the risk inherent in the whole financial system. Beta coefficient is an important input in capital asset pricing model

to calculate required rate of return on a stock. It is the slope of the security market line.

Formula

Beta coefficient is calculated as covariance of a stock's return with market returns divided by variance of market return. A

slight modification helps in building another key relationship which tells that beta coefficient equals correlation coefficient

multiplied by standard deviation of stock returns divided by standard deviation of market returns. Beta coefficient is given

by the following formulas:

= Covariance of Market Return with Stock Return

Variance of Market Return

=

Correlation Coefficient

Standard Deviation of Stock Returns

Between Market and Stock Standard Deviation of Market Returns

Analysis

A beta coefficient of 1 suggests that the stock carries the same risk as the overall market and will earn market return only. A

coefficient below 1 suggests a below average risk and return (where the average means the overall market) while on the

other hand a coefficient higher than 1 suggests an above average risk and return.

At the time of writing (Dec 2012), ExxonMobil (NYSE: XOM) has a beta of 0.63 which suggests that less risky than average

market. JPMorgan Chase (NYSE: JPM) on the other hand has a beta of 1.58 and we can conclude it is more risky than the

market in general.

Estimating Beta Coefficient

Suppose correlation coefficient between market and share price of Company P is 0.75; standard deviation of market is 15%

and that of share price is 8%, beta can equals 0.40 (=0.75 8%/15%).

If we do not have these variables estimating beta from raw data is not very difficult. Just follow these simple steps to

estimate beta:

1. Obtain historical share price data for the company's share price.

2. Obtain historical values of an appropriate capital market index (say S&P500).

3. Convert the share price values into daily return values by using the following formula: return = (closing share

price opening share price)/opening share price.

4. Convert historical stock market index values in similar way.

5. Align the share return data with index return such that there is 1-on-1 correspondence between them. For

share price return on 11 December 2011 there should be a corresponding index return.

6. Using SLOPE function to find the slope between the both arrays of data and resultant figure is beta.

Yield to Maturity (YTM)

Yield to maturity (YTM) is the rate of return expected on a bond which is held till maturity. It is essentially the internal rate

of return on a bond and it equates the present value of bond future cash flows to its current market price.

Formula

If m is the number of coupons in a year and n is number of years the following equations can be used to find the yield to

maturity.

Bond Price = Par Value Coupon Rate

1 (1 + r)

mn

+

Par Value

r (1 + r)

mn

Yield to Maturity = r m

The figure is calculated by trial and error in which we plug discount rates into the equation developed above until we find a

rate which satisfies the equation (i.e. right hand side of the equation equals left hand side).

Example

Company D's 10-year bond with par value of $1,000 and semiannual coupon of 8% is currently trading at $950. Find the

yield to maturity on the bond.

Solution

We defined yield to maturity as the rate which discounts the bond's future cash flows (coupons and par value) such that

their present value equals the bond's market price. Company D's bond has a par value of $1,000; semiannual coupon of $40

(=8%/2$1,000) and price of $950.

We get the following relationship after plugging in the variables:

$950 = $1000 4%

1 (1 + r)

102

+

$1000

r (1 + r)

102

There is an interesting relationship between bond price and yield to maturity:

1. If yield to maturity is equal to the coupon rate the bond is trading at par.

2. If the yield to maturity is lower than the coupon rate the bond will be trading above par (which means trading

at premium).

3. If the yield to maturity is higher than the coupon rate the bond will be trading below par (which means trading

at discount).

In the example above price is $950 which is lower than the par (which is $1,000). This suggests that the yield to maturity

must be higher than the coupon rate (which is 4%). While using trial and error method we will start with discount rates

above 4% and narrow down to until the present value is almost equal to the price. In the above example, discount rate of

4% gives price of $1,000; 4.5% gives a price of $935. From this we follow that we need focus on discount rates between 4%

and 4.5%. A rate of 4.25% gives a price of $967 and 9.45% gives a price of $941. We keep narrowing down until we get the

discount rate which exactly reduces the left hand side of the bond price equation to current bond price. For Company D's

bond this rate is 4.38%. Yield to maturity is expressed as an annual rate so it equals 8.76% (=4.38%2).

Limitation of Yield to Maturity

Yield to maturity carries the same drawback as an internal rate of return: it assumes that the coupon payments are

reinvested at the yield to maturity which is not normally the case. If coupons are to be reinvested at lower rates yield to

maturity will be an overstated figure.

There are many other similar measures used such as yield to call, yield to put, cash flows yield, etc.

Current Yield

Current yield is a measure of rate of return on a bond. It is calculated as a bond's annual coupon divided by its current price.

Together with coupon rate and yield to maturity it is an important but simple measure of return on a bond.

Example:

Company Z's 20-year $1,000 par bonds have a price of $970 and annual coupon rate of 9%. Find its current yield.

Solution:

Annual coupon is $90 ($1,000 9%). Current market price is $970 so current yield is $90/$970 which equals 9.28%.

Relationship between coupon rate, current yield and yield to maturity

There is an interesting relationship between the three measures of bond return namely yield to maturity, coupon rate and

current yield.

1. If the bond is trading at par current yield equals coupon rate which in turn equals yield to maturity.

2. If the bond is trading below par (trading at discount) yield to maturity is higher than current yield which is in

turn higher than the coupon rate.

3. If the bond is trading above part (trading at premium) coupon rate is higher than current yield which is in turn

higher than the yield to maturity.

Corporate Finance Introduction

Money makes a business go and that money comes from different sources, namely equity and debt. Corporate finance is

the study of sources of finance and how to use the money raised to add maximum value to the shareholders' wealth.

It discusses topics such as:

1. Models for calculation of cost of common stock, cost of preferred stock and cost of debt;

2. Calculation of weighted average cost of capital and its use in investment appraisal techniques such as net

present value, internal rate of return, profitability index, payback period, etc.;

3. Accounting for risk in investment appraisal techniques using sensitivity analysis, scenario analysis, etc.;

4. Decision about whether to declare a dividend or whether reinvest the money in business;

5. Working capital management: management of inventories, receivables and cash;

6. Calculation of investment performance valuation parameters such as ROI, ROE, etc.

7. Financial risk management using derivatives and other techniques

Corporate finance managers are one of the most common users of financial accounting information and they need to

coordinate with other functions of the business such as production, marketing, administration, etc.

Forms of Business

In accounting business refers to an organization which carries out activities such as purchasing goods and services from

other businesses or manufacturing goods and services by its own and then selling them to consumers with an intention that

the business earns profit thus increasing the wealth of the owner(s) of that business.

Types

Business can be owned by one person, or by a small group of people who have agreed to share profits, or by tons of people

who own small portion of the business. Thus, according to number of owners, businesses can be classified as follows:

Sole Proprietorship: A business owned by a single person.

Partnership: A business owned by few people who mutually agree to share profits of the business.

Corporations: A business owned by tons of people, each owning a small portion of the business.

Sole Proprietorship

A sole proprietorship is the simplest form of business organization because it is run by just one person. There is little

complexity in starting up a sole proprietorship because it may involve just getting a license and finding some premises. This

is why most of the businesses are in the form of sole proprietorship. It is normally feasible for service providers such as

physicians, freelancers, accountants, etc.

Advantages

1. The owner keeps all the profits.

2. There is little complexity in setting up a sole proprietorship.

3. Small amount of capital is sufficient for startup.

Disadvantages

1. It has unlimited liability of business debts which means that the debts that the owner obtains for the purpose

of business are recovered from the personal assets of the owner if the business assets are insufficient to

discharge them.

2. The income is taxed collectively with the owner's income from other sources this may make the owner liable

to tax at a higher rate.

3. The life of a sole proprietorship is limited to the owner's life span.

4. Sole proprietorship's capital raising opportunity is limited mostly to the resources of the owner. This puts a

constraint on the growth of business.

5. Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the sale of the

sale of the whole business to the new owner.

Partnership

Partnership is a type of business in which two or more persons mutually own and operate the business and agree to share

profits equally or according to profit sharing ratio. It is similar to sole proprietorship in many ways. There are two main sub-

classifications of partnerships:

General Partnership:

A partnership in which all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not

just some particular share. For example if A and B setup a partnership, they share profits and losses equally. The

partnership defaults on a loan of $200,000. Only $100,000 is recoverable from the partnership assets. The remaining

$100,000 will recovered from A & B $50,000 each if both can pay, but if say A is not able to pay anything, the entire

$100,000 can be recovered from the personal assets of B.

Limited Partnership:

In which there are one or more general partners and one or more limited partners. General partners run the business and

have unlimited liability, but limited partners although owners do not actively participate in the business. The general

partner's liability is unlimited just like the owner of a sole proprietorship, but a limited partner's liability for business debts

is limited to the amount that partner contributes to the partnership which means that nothing will be recovered from a

limited partner's personal assets. This form of organization is common in real estate ventures, public accounting, etc.

Advantages and Disadvantages

The advantages and disadvantages of a partnership are basically the same as those of a proprietorship. But in some

instances, there are some differences outlined below:

1. The partnership terminates when any of the general partners sells its assets. A new partnership is formed if

the other partnership accepts the purchaser of such share as a partner.

2. All income is taxed as personal income to the partners as in sole proprietorship.

3. More capital can be raised due to involvement of more individuals.

4. Ownership of a general partnership is not easily transferred, because a transfer requires that a new

partnership be formed. However, a limited partner may sell his share without dissolving the partnership.

5. In case of general partnership a written agreement called partnership agreement is required.

Corporation

Corporation is a type of business which is formally registered as a public owned company it is recognized as a separate

entity from its owners.

The three main disadvantages of sole proprietorships and partnerships are:

Advantages

The popularity of corporations is due to following advantages:

1. The liability of the owners towards the creditors is limited to their investment in the company. This means that

in case of liquidation of the company, if the company's assets are insufficient to meet the liability, nothing is

required to be contributed by the owners. Only the owners' contribution is at stake rather than their personal

assets.

2. The corporation is considered a legal person with perpetual existence. It exists until it is liquidated and death

or change in ownership has no effect on the corporation.

3. Additional capital can be raised easily through stock markets, etc.

4. The ownership is represented by the number of share certificates held by a person, and this makes the transfer

of ownership very easy.

Disadvantages

Following are the disadvantages of a corporation:

1. Establishing a corporation is a complex process and requires registration with the central regulatory authority

and listing on a stock exchange which required fulfillment of certain requirements related to the amount of

capital, number of directors, etc.

2. Normally the corporations have a large number of shareholders; they delegate the governance function to a

body of persons called board of directors. The board of directors hires management to look after the day to

day affairs of the corporation. The management is an agent and the owners are principal. It is quite possible

that the management may act to further its own interest rather than the interest of the owners of the

corporation. When this happens it is called an agency problem.

3. In case of corporations there is double taxation. First of all the corporate income is taxed at a flat rate and then

the dividends paid to the shareholders is taxed.

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