Chapter-1

Cost Accounting:

Cost Accounting identifies, defines, measures, reports and analyzes the various elements of
direct and indirect costs associated with producing and marketing goods and services. Originally
cost accounting dealt with ways of accumulating historical costs and of charging these costs to
units of output, or to department, in order to establish inventory valuations, profits or losses and
balance sheet items. So cost accounting has been extended in to planning, control and decision
making.

Cost accounting is concerned with providing information to assist the following:

 Establishing inventory valuation, profits or losses and balance sheet items

 Planning
 Control
 Decision making

What are the differences between management accounts and financial accounts.N/D-11

Financial accounting Management accounting

1. Financial accounts detail the performance of 1. Management accounting which is basically

an organization over defined period, including concerned with the provision of information to
the cash flows. assist management with planning, control and
decision making.
2. Financial accountants are usually prepared 2. Management accounts are usually prepared
for external to an organization. for internal managers of an organization.
3. The format of financial accounts is 3. The format of management accounts is
determined by IFRS. entirely at management discretion.
4. In Bangladesh, limited companies must, by 4. There is no legal requirement.
law.
5. Financial accounts often concentrate on the 5. Management accounts can focus on specific
business as a whole. areas of an organization’s activities such as
operating departments.
6. It is a monetary nature. 6. It is a non-monetary nature.

Define opportunity cost and sunk cost. N/D-11

Cost objects M/J-13, N/D-13

A Cost object is anything for which we are trying to ascertain the cost.
Example of cost object:

 A unit of product
 A unit of services
 A department or functions
 A project
 A new product or service.

What is Cost Unit? M/J-13, N/D-13, N/D-14

A cost unit is a basic measure of a product or service for which costs are determined.

Organization Possible Cost Units

1.Steelworks  Tonne of steel produced
 Tonne of coke used
2.Hospital  Hospital Patient/day
 Operation
 Out-patient visit
3.Freight organisation  Tonne/kilometre
4.Passenger transport organisation  Passenger/kilometre
5.Accounting firm  Audit performed
 Chargeable hour
6.Restaurant  Meal served

Composite cost unit

Some of the cost units are made up of two parts, for example patient/day cost unit for hospital.
These two part known as composite units and they are used most often in service organizations.
Composite cost units help to improve cost control.

What are the cost elements?

 Material
 Labor
 Other expenses

Cost elements can be classified as direct costs or indirect costs as far as cost units are concerned.

Direct cost. M/J-15

A direct cost is a cost that can be traced in full to the cost unit.

There are three types of direct cost.

  Direct material costs are the costs of materials that are known to have been used in
making and selling a unit of product (or providing a service). Examples are components
and packing materials.
 Direct labour costs are the specific costs of the workforce used to make a unit of product
or provide a service.
 Other direct expenses are those expenses that have been incurred in full as a direct
consequence of making a unit of product, or providing a service, or running a department.

Prime Cost

Total direct cost can be described as “Prime Cost”.

Prime Cost = Total direct cost = direct material cost + direct labour cost + other direct expenses.

Indirect cost. M/J-15

Indirect cost (or overhead): A cost that is incurred which cannot be traced directly and in full
to the cost unit.

Example of indirect cost: cost of supervisor’ wage on a production line, cleaning material and
building insurance for a factory. These cost can not be traced directly.

Categories of Overhead. M/J-14

1. Production overhead 2. Administration overhead

3. Selling overhead 4. Distribution overhead

1. Production overhead:

 Indirect materials,
 Indirect wages,
 Indirect expenses

2. Administration overhead:

 Depreciation of office equipment

 Office salaries, including the salaries of secretaries and accountants
 Rent, rates, insurance, telephone, heat and light cost of general offices

3. Selling overhead:

 Printing and stationery

 Salaries and commission of sales representatives
 Rent, rates and insurance for sales offices and showrooms
4. Distribution overhead:

 Cost of packing cases

 Wages of packers, drivers and despatch clerks
 Depreciation and running expenses of delivery vehicles

Product cost & Period cost. N/D-14, M/J-15, N/D-15

Product cost: product costs are costs identified with goods produced or purchased for sale.

Period cost: Period costs are costs deducted as expenses during a particular period.

Cost Behavior Pattern:

Cost behavior pattern means grouping costs according to how they vary in relation to the level of
activity.

Example of level of activity:

 The volume of production in a period

 The number of items sold
 The number of invoice issued
 The number of units of electricity consumed

Planning and decision-making are concerned with future events and so managers require
information on expected future costs and revenues. A knowledge of how the cost incurred
varies at different levels of activity is essential to planning and decision-making.

Fixed cost. M/J-13,M/J-17

Fixed cost: A fixed cost is a cost, within a relevant range of activity levels, is not affected by
increased or decreased in the level of activity.

Examples of fixed costs include the following.

 The salary of the managing director (per month or per annum)

 The rent of a single factory building (per month or per annum)
 Straight line depreciation of a single machine (per month or per annum)

What is variable cost?M/J-13, M/J-17

A variable cost is a cost that increases or decreases as the level of increases or decreases.

 the cost of raw materials,

 direct labor cost,
 sales commission,
What is Semi variable or semi fixed or mixed cost? M/J-13, M/J-14, M/J-17

Semi-fixed or semi-variable or mixed cots are part-fixed and part-variable and are therefore
partly affected by change in the level of activity.

 electricity and gas bill,

 sales representatives’ salary,

What is relevant range?

The relevant range is the range of activity levels within which assumed cost behavior patterns
occur.

What is responsibility accounting? M/J-14

Responsibility accounting is a system of accounting that segregates revenue and costs into areas
of personal responsibility to monitor and assess the performance of each part of an organization.

Responsibility centre:

A responsibility centre is department or function whose performance is direct responsibility of a

specific manger.

Controllable cost? M/J-10, M/J-14

A controllable cost is a cost that can be influenced by the management actions and decisions.

Uncontrollable cost? M/J-10

An uncontrollable cost is a cost that cannot be affected by the management within a given time
span.
 Chapter -2

Direct and Indirect Costs few possible misconceptions

 Direct costs are not necessarily bigger in size than indirect costs.
 Indirect costs are not less important than direct costs.
 It is easy to confuse fixed and variable costs with indirect and direct costs.

1. FIFO Method: Assumes that materials are issued out of inventory in the order in which they
were delivered into inventory, issues are priced at the cost of the earliest delivery remaining in
inventory.

Advantages:

 It is a logical method.
 It is easy to understand and explain to managers.
 The inventory valuation can be near to a valuation based replacement cost.

Disadvantages:

 FIFO can be cumbersome to operate.

 Managers may find it difficult to compare costs and make decisions.
 In a period of high inflation, inventory issue prices will lag behind current market value.

Under circumstances FIFO method is used

 Falling price of cost of materials,

 Inventories are perishable in nature,
 Size and cost of materials are large,
 Close to expire (raw material used in pharmaceutical companies).

2. LIFO Method: assumes that materials are issued out of inventory in the reverse order from
that in which they were delivered, the most recent deliveries are issued earlier ones, and issues
are priced accordingly.

Advantages: N/D-13

 Inventories are issued at a price which is close to current market value.

 Managers are continually aware of recent costs when making decisions.

Disadvantages: N/D-13

 The method can be cumbersome.

 It is difficult to explain the managers.
 As with FIFO, decisions making can be difficult because of the variations in prices.
3. Cumulative weighted average pricing

The cumulative weighted average pricing method calculates a weighted average price for all
units in inventory. Issues are priced at this average cost, and the balance of inventory remaining
would have the same unit valuation. The average price is determined by dividing the total cost by
the total number of units.

A new weighted average price is calculated whenever a new delivery of materials is received
into store. This is the key feature of cumulative weighted average pricing.

Advantages of cumulative weighted average pricing. N/D-12

 Fluctuations in prices are smoothed out, making it easier to use the data for making
decision.
 It is easier to administer than FIFO and LIFO, because there is no need to identify each
batch separately.

Disadvantages of Cumulative average pricing? N/D-12

 The resulting issue price is rarely an actual price that has been paid, and can run several
decimal places.
 Prices tend to lag a little behind current market values when there is gradual inflation.

During periods of rising prices, what will be the effect on the financial statements if FIFO
method is used instead of LIFO method for valuation of inventory? N/D-14

During periods of rising prices, the use of FIFO will result in higher inventory, lower cost of
goods sold, and higher gross prosfit, net income, income taxes, and retained earnings

Errors occasionally occur during physical counting of the inventory. Identify the effects on
the financial statements of an overstatement of the ending inventory in the current period.
If the error is not corrected, how does it affect the financial statements for the following
year? N/D-14

The overstatement of ending inventory will cause cost of goods sold to be understated.
Consequently, net income for the period will be overstated. The effect on the balance sheet is
that assets and owner’s equity will be overstated.

If error is not corrected the subsequent period will have an overstatement of begaining inventory.
This will cause cost of goods sold to be overstated and net income to be understated,
counterbalancing the overstatement of income in the prior period.
 Chapter-3
Over and under absorption of overheads

The overhead absorption rate is based on estimates (of both numerator and denominator) and it is
quite likely that either one or both of the estimates will not agree with what actually occurs.
Actual overheads incurred are unlikely to be equal to the overheads absorbed into the cost of
production.

(a) Over absorption means that the overheads charged to the cost of production are greater than
the overheads actually incurred.

(b) Under absorption means that insufficient overheads have been included in the cost of
production.

The reasons for under/over absorbed overhead. M/J-12

The overhead absorption rate is predetermined from budget estimates of overhead cost and the
expected volume of activity. Under or over recovery of overhead will occur in the following
circumstances.

 Actual overhead costs are different from budgeted overheads; or

 The actual activity level is different from the budgeted activity level.

ABC (activity based costing) approach:

Activity based costing (ABC) is an alternative approach to absorption costing. ABC involves the
identification of the factors that cause the costs of an organization’s major activities.

 Step 1: identify an organization’s major activities.

 Step 2: identify the factors which cause the costs of the activities.
 Step 3: collect the costs associated with each activity into cost pools.
 Step 4:charge the costs of activities to products on the basis of their usage of the
activities.

The problem with traditional absorption costing. N/D-13

A significant feature of many modern businesses is the relatively high level of overhead costs in
relation to total costs. In this situation, the traditional absorption costing system can create a
problem for management seeking to accurately identify unit costs and exert control over these
costs. This problem has particular significance given the highly competitive environment faced
by many businesses.
Types of costing methods:

 Job costing: job costing is appropriate where each separately identifiable cost unit or job
is of relatively short duration, such as the plumber services and the garden bench.
 Contract costing: contract is appropriate where each separately identifiable cost unit is
of relatively long duration, such as the building of the school or hospital
 Batch costing: batch costing is similar to job costing except that each separately
identifiable cost unit would be a batch of identical items.

Product life cycle costing: life cycle costing tracks and accumulates the costs and revenues
attributable to each product over its entire life cycle.

Component elements of a product’s costs over its life cycle include the following:

i. Research and development costs: design, testing

ii. Training costs: including initial operator training

iii. Production costs: materials, labour

iv. Distribution costs: transportation, handling, inventory cost

v. Marketing costs: advertising, customer service

vi. Retirement costs: dismantling specialized equipment.

Just in time (JIT):

Just in time as an approach to operations planning and control based on the idea that goods and
services should be produced only when they are needed.

Operational requirements for JIT:

 High quality
 Speed
 Reliability
 Flexibility
 Efficient production planning
 Reliable sales forecasting.

JIT and cost management:

An efficient JIT system enables managers to control and reduces costs in a number of areas,
including the following:
  Warehousing costs
 Improved capacity utilization
 Reducing in waste
 Reduction in write-offs due to obsolescence.

Predetermined absorption rates. N/D-14

In absorption costing, it is usual to add overheads into product costs by applying a

predetermined overhead absorption rate. The predetermined rate is usually set annually in
advance, as part of the budgetary planning process.

Calculating predetermined overhead absorption rates. N/D-14

The absorption rate is calculated by dividing the budgeted overhead by the budgeted level of
activity. For production overheads the level of activity is often budgeted direct labour hours or
budgeted machine hours.

Overhead absorption rates are therefore predetermined as follows.

 The overhead likely to be incurred during the coming period is estimated.

 The total hours, units, or direct costs on which the overhead absorption rates are to be
based (the activity level) are estimated.
 The estimated overhead is divided by the budgeted activity level to arrive at an
absorption rate for the forthcoming period.

“Unused capacity should be treated as a general cost to be shared across all product lines.”
Do you agree? Explain. N/D-16

Do not agree,

Explanation: In general, unused capacity is not assigned to product lines. However, if the
capacity was acquired to meet anticipated demands from a particular customer or a particular
market segment, the costs of unused capacity due to lower-than-expected demands can be
assigned to the person or organizational unit responsible for that customer or segment. Such an
assignment is done on a lump-sum basis to the organizational unit; it should not be driven down
to the products actually produced during the period in the unit.

Do activity-based costing systems always provide more accurate product costs than
conventional cost systems? Why or why not? M/J-17

No, Traditional systems contain smaller and fewer cost distortions when the traditional systems’
unit-level assignment and the alternative activity-cost drivers are relatively similar in proportion
to each other. Still, the use of unit-level measures to assign indirect costs is more likely to under
cost low-volume products and more complex products. Both traditional product- costing systems
and ABC product costing systems seek to assign all manufacturing costs to products. Cost
distortions occur when a mismatch occurs between the way support costs are incurred and the
basis for their assignment to individual products.
 Chapter-4
What is Marginal costing

In a marginal costing system only variable production costs are included in the valuations of
units. All fixed cost are treated as period costs and are charged in full against the sales revenues
for the period.

The marginal production cost per unit usually consists of the following:

 Variable materials
 Variable labour
 Variable production overheads

Contribution

Contribution is an important measure in marginal costing, and it is calculated as the difference

between sales value and marginal cost.

The term 'contribution' is really short for 'contribution towards fixed overheads and profit'.

Differences between marginal costing and absorption costing: N/D-15

The differences between the two costing systems can be summarized as follows:

In marginal costing:

 Closing inventories are valued at marginal or variable production cost.

 Fixed costs are charged in full against the profit of the period in which they are incurred.
 No fixed costs are included in the inventory valuation.

In absorption costing:

 Inventories are valued at full production cost, and included a share of fixed production
costs.
 This means that the cost of sales in a period will included some fixed overhead incurred
in a previous period and will exclude some fixed overhead incurred in the current period
which is carried forward in the closing inventory value.

Advantages of absorption costing:

 Fixed production costs are incurred in order to make output.

 Closing inventory values, by including a share of fixed production overhead, will be
valued on the principle required by accounting standards for the financial accounting
valuation of inventories for external reporting purposes.
Advantages of marginal costing:

 It is simple to operate.
 There are no apportionments of fixed costs.
 Fixed costs will be the same regardless of the volume of output.
 Under or over absorption of overheads is avoided.
 Marginal costing information can be more useful for decision

Absorption costing and Marginal costing the two techniques are not truly alternatives.
Explain it? M/J-11

Absorption costing and Marginal costing the two techniques are not truly alternatives.
Absorption costing is often used as a technique of cost finding in business, but marginal costing
is used as a technique of cost analysis for decision making.

Why does Marginal costing technique excludes Fixed costs. Explain briefly. M/J-11

In marginal costing technique, fixed cost are kept outside the preview of product cost, and such a
method is justified on the following grounds:

 When fixed costs are included in product costs, variation occurs in the unit cost of
products produced during different periods. As such, distortions occurs in the trading
result.
 While the volume of output varies from month owing to several reasons, fixed costs
remain constant.
 When one facilities are installed and the same are not changed, fixed cost must be
incurred regardless of the utilization of the facilities.
 Since variable costs are relevant to current operations, fixed costs should be considered as
a separate entity.

In what situations is absorption costing more appropriate than marginal costing? M/J-12

Absorption costing is more appropriate than marginal costing in the following situations:

 Long run pricing: In the long run both marginal cost and overheads need to be covered;
using absorption costing ensures this will be so.
 Financial Accounting: The standardization of external reporting requirements requires
that a reasonable proportion of overheads be included in stock valuations. Many
companies want the external and internal accounts to reveal the same level of profits.

Why is absorption costing more widely used than variable costing? N/D-16

Absorption costing is more widely used than variable costing for following Reasons:

 Variable costing is not allowed for tax purposes, but absorption costing is allowed.
  Variable costing is not allowed for external reports as it is not supported by International
Accounting Standards, but absorption costing is allowed.

Expalin the situation whether you are agree or not for the following two statements.M/J-15

(i) When Closing inventory levels are higher than opening inventory levels and
overheads are constant, absorption costing gives a higher profit than marginal
costing.
(ii) A product showing a loss under absorption costing will also make a negative
contribution under marginal costing.

(i) I fully agree with the statement. “ When Closing inventory levels are higher than opening
inventory levels and overheads are constant, absorption costing gives a higher profit than
marginal costing.” Because an increase in inventory levels wil mean that with absorption costing
more overheads is being carried forward at the end of the period than at the start of the period.
Thos means that overheads charged against profits in the period would be lower than under
marginal costing thereby increasing the reported profit.

(ii) The statement “A product showing a loss under absorption costing will also make a negative
contribution under marginal costing” is not true because a product could earn a contribution
under mrginal costing which then becomes a gross loss under absorption costing only because of
the increase in cost from absorbing fixed overheads.

Explain throughput costing? What advantages is it purported to have over variable and
absorption costing.N/D-17

Through put costing is an inventory method which treats all costs except direct materials as costs
of the period in which they are incurred. Through put costing results in a lower amount of
manufacturing cost put into inventory than either variable or absorption costing. Supporters of
throughput costing claim that it provides less incentive to produce for inventory than absorption
costing or even variable costing.
 Chapter-5
What is cost-plus pricing? Briefly describe the methods of determining sales prices under
cost-plus pricing? M/J-16

Cost-plus pricing: Cost is one of the most important influences on price of a product or service.
Cost-plus pricing means the determination of sales price by calculating the cost of the product or
service and then adding a percentage mark-up for profit.

There are two methods of cost-plus pricing and these are as follows:

1. Full cost-plus pricing: In full cost-plus pricing the sales price is determined by
calculating the full cost of the product or service and then adding a percentage mark-up
for profit.
2. Marginal cost- plus pricing: Marginal cost-plus pricing involves adding a profit mark-
up to the marginal or variable cost of production or sales.

Advantages of full cost-plus pricing:

 The price is quick and easy to calculate.

 Pricing decisions can be delegated to more junior employees.
 Price increase can be justified.
 Ensure that an organization working at normal capacity will cover all its costs.

What are the disadvantages of Full cost-plus pricing?

 It fails to recognize that since demand may be determining price, there will be a profit
maximizing combination of price and demand.
 It reduces incentives to control costs.
 It requires arbitrary absorption of overheads into product costs.
 If full cost-plus pricing is applied strictly the organization may be caught in a vicious
circle.

Marginal cost- plus pricing: N/D-11,

Marginal cost-plus pricing involves adding a profit mark-up to the marginal or variable cost of
production or sales.

Advantages of marginal cost-plus pricing:

 It is a simple method to use.

 It avoids the arbitrary apportionment and absorption of fixed cost.
 It is more useful than total cost-plus pricing for short-term management decision making.
Disadvantages of marginal cost-plus pricing:

 The full costs might be recovered in the long term.

 It does not ensure that sufficient attention is paid to demand conditions, competitors
prices or profit maximization.

Mark-up: the mark-up is the profit expressed as a percentage of the marginal cost, total
production cost or total cost.

Margins: the margin is the profit expressed as a percentage of the sales price.

The differences between mark-up and margin: M/J-16

Mark-up percentage: profit expressed as a percentage of cost.

Margin percentage: profit expressed as a percentage of sales price.

Example: Product Q incurs a total cost of CU80 per unit and its selling price is set at CU100 per
unit.

The mark-up applied to product Q = (CU20/CU80) * 100%

= 25% of total cost

The margin earned by product Q = (CU20/CU100) * 100%

= 20% of sales pric

What is a transfer price? M/J-11,

A transfer price is the amount charged by one part of an organization for the provision of goods
or services to another part of the same organization.

Aims of a transfer pricing system: M/J-12

 To enable the realistic measurement of divisional profit.

 To provide the supplier with a realistic profit and the receiver with a realistic cost.
 To give autonomy to managers.
 To ensure profit maximization.
 To encourage goal congruence.

Practical methods of transfer pricing:

 Market price
 Cost-plus price
 Two part transfer price
 Dual price.
A selling price in excess of the full cost per unit will always result in an overall profit for
the ' organization - Do you agree? Please explain.N/D-17

The statement is incorrect.

This is because full cost includes fixed cost per unit which have been derived based on estimated
or budgeted sales volumes. If the budgeted volumes are not achieved then the actual fixed cost
per unit will be higher than estimated and the selling price might be lower than the actual cost
per unit.

What factors may influence the level of markups? N/D-17

Factors affecting the level of markups include the strength of demand, the elasticity of demand,
and the intensity of competition. In addition, strategic reasons also may influence the level of
markups. For instance, a firm may either choose a low markup to penetrate the market and win
market share from established products of its competitors, or employ a high markup if it employs
a skimming strategy for a market segment in which some customers are willing to pay higher
prices for the privilege of owning the product.
 Chapter-6
What is budget? N/D-10

A budget is a plan of what the organization intends should happen.

What is forecast? N/D-10

A forecast is a prediction of what is likely to happen.

Why do organizations prepare budgets?

i. Compel planning
ii. Communicate ideas and plans
iii. Coordinate activities
iv. Means of allocating resources
v. Authorization
vi. Provide a framework for responsibility accounting
vii. Establish a system of control
viii. Provide a means of performance evaluation
ix. Motivate employees to improve their performance

Budgeted compare with forecast: N/D-10

A forecast is a prediction of what is likely to happen in the future, given a certain set of
circumstances. This is different from a budget, which is a qualified plan of what the organization
intends should happen in the future. The budget is based on the forecast.

Budget period: The budget period is the period covered by the budget, which is usually one year.

What is budget committee?

The budget committee is the coordinating body in the preparation and administration of budgets.

Functions of the budget committee:

 Coordination and allocation of responsibility for the preparation of budget.

 Issuing of the budget manual.
 Timetabling.
 Provision of information to assist in the preparation of budget.
 Communication of final budget to the appropriate managers.
 Monitoring the budgeting process by comparing actual and budget results.
What is budget manual?

The budget manual is a collection of instructions governing the responsibilities of persons and
the procedures, forms and records relating to the preparation and use of budgetary data.

A budget manual may contain the following:

 The objectives of the budgetary process.

 Organizational structures
 A outline of the principle budgets and the relationship between them
 Administrative details of budget preparation
 Procedural matters.

What is master budget?

The master budget provides a consolidation of all the subsidiary budgets and normally comprises
a budgeted income statement, a budgeted balance sheet and a cash budget.

The master budget consists of:

 The budgeted income statement

 The budgeted balance sheet and
 The cash budget

What is zero based budgeting? N/D-10, M/J-14

Zero based budgeting is an approach to budgeting that attempts to ensure that inefficiencies are
not concealed.

Zero based budgeting all budgets to be prepared from the very beginning or zero.

Advantage of ZBB

 Increments of expenditure are compared with the expected benefits received, to ensure
that resources are allocated as efficiently as possible.
 ZBB can be particularly useful when applied to discretionary costs such as marketing and
training costs. This type of cost is not vital to the continued existence of an organisation
in the way that, say, raw materials are to a manufacturing business.

Disadvantage of ZBB

A major disadvantage of ZBB is that it is a time-consuming task that involves a great deal of
work.
Participation in the budgeting process:

1. Imposed or top-down style of budgeting: in this approach to budgeting, top

management prepare a budget with little or no input from operating personnel, which is
then imposed upon the employees who have to work to the budgeted figures.

The time when imposed budgets are effective:

i. In newly-formed organizations
ii. In very small businesses
iii. During periods of economic hardship
iv. When the organization’s different units require precise coordination

Advantages:

 They enhance the coordination between the plans and objectives of divisions
 They use senior management’s awareness of total resources availability
 They decrease the input from inexperienced lower- level employees
 They decrease the period of time taken to draw up the budgets

Disadvantages:


Dissatisfaction, defensiveness and low morale amongst employees

The feeling of term spirit may disappear

The acceptances of organizational goals and objectives could be limited

The budget may be viewed as a punitive device

Lower-level management initiative may be stifled

Participative or bottom-up style of budgeting: In this approach to budgeting, budgets are
developed by lower-level managers who then submit the budgets to their superior. The budgets
are based on the lower-level manager’s perceptions of what is achievable and the associated
necessary resources.

Advantages of participative budgets:

 They are based on information from the employees most familiar with the department
 Knowledge spread among several levels of management is pulled together
 Morale and motivation is improved
 They increase operational managers commitment to organizational objectives
 In general they are more realistic
 Co-ordination between units is improved
 Specific resources requirements are included
Disadvantages of participative budgets:

 They consume more time

 Changes implemented by senior management may cause dissatisfaction
 Budgets may be unachievable or much too soft if managers are not qualified to
participate
 They can support ‘empire building’ by subordinates
 An earlier start to the budgeting process could be required

What is rolling budget?

Rolling budget, also known as continuous budgets, are continuously updated by adding a further
month or quarter to the end of the budget as each month or quarter comes to a close.

Advantages of rolling budget:

i. They reduce the element of uncertainty in budgeting.

ii. They force managers to reassess the budget regularly.

iii. Planning and control will be based on a recent plan.

iv. There is always a budget that extends for several months ahead.

Disadvantages of rolling budget:

i. This involves more time, effort and money in budget preparation.

Incremental budget: M/J-14

The traditional approach to budgeting is to base the forthcoming year’s results modified for
changes in activity levels. This approach is known as incremental budgeting since it is concerned
mainly with the increments in costs and revenues which will occur in the period.

Incremental budgeting is a reasonable approach if the current operations are as effective,

efficient and economic as they can be.

Alternative budget structures:

 Product based budget: this structure is appropriate when the cost and revenue
responsibilities differ for each product, or when a single manager is responsible for all
aspects of one product.
 Responsibility based budget: responsibility based budget systems segregate budgeted
revenues and costs into areas of personal responsibility in order to monitor and assess the
performance of each part of an organization.
  Activity based budget: activity based budgets are based on a framework of activities,
and cost drivers are used as a basis for preparing budgets.

What are the essentials of effective budgeting? ?N/D-10

 Support of Top Management

 Formal Organization
 Preparation by Responsible Executives
 Clear-cut Objectives and Reasonably attainable Goals
 Budget Commettee
 Comprehensive Budgeting
 Adequate Acounting System
 Periodic Reporting
 Budget Education

Describe some of the drawbacks of using the operating budget as a control device. M/J-16,
M/J-17

When the operating budget is used as a control device, it can lead to behaviour that is actually
detrimental to the organization.

The major problem with the budget performance report is not the report itself, but rather the way
it is used. In general, managers are rewarded for favourable variances, and disciplined for
unfavourable variences. This encourages managers to set lax standard for both sales and costs so
favourable variences result. It can also lead to “budget games”.

Another drawback is that once the budget is established, if there is any varience between budget
and actual, it is assumed to be because of actual. However, as we know, the budget will never be
totally accurate due to the uncertainities of predicting the future.

If used properly, however, the operating budget can be a tremendaous benefit to any company.
 Chapter-7
What is cash budget? M/J-13

A cash budget is a statement in which estimated future cash receipts and payments are tabulated
in such a way as to show the forecast cash balance of a business at defined intervals.

The usefulness of cash budgets:

Cash budget enable management to make any forward planning decision that may be needed.
The cash budget also gives management an indication of potential problems.

Is useful of cash budget in managerial decision making. M/J-13

Cash budget helps the managers to identify and estimate the sources of cash generation and its
applications. It helps the management to foresee the excessive idle cash balances or cash sortage
that is expected during the period and to plan accordingly. For example if any cash shortage is
expected, 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. This process ensures
both uninterrupted support to the day to day operation and efficient management of funds.

What is the cash operating cycle? N/D-12, N/D-14

The cash operating cycle is the length of time between paying out cash for raw materials and
other input costs and receiving the cash for goods or services supplied.

The signifies of the cash operating cycle:

The amount of cash required to fund the cash operating cycle will increase as:

 The cycle gets longer

 Sales increase

Importance of cash operating cycle. N/D-12

Cash operating cycle is very important tool for management to determine the level of cash
involved and work on it to keep it within optimum level. Shorter is the cash operating cycle the
lower will be the level of working capital needs.

What are the two methods of preparing Cash Budgeting? M/J-11

Methods of preparing Cash Budgeting:

1. Receipts and payments method: This method is useful for short term estimations.
Under this method items should be categorized in two ways- Operating Cash Flows, Non-
Operating Cash-Flows.
 2. Balance Sheet method: This method is useful for long term estimations.

Distinguish between Cash Budgeting and Cash Flow statement. M/J-11

The following are the imortant Distinguish between Cash Budgeting and Cash Flow statement

 The cash budget is for planning for the future while the cash flow statement looks at the
past.
 A budget is a plan for how to spend/save money. A cash flow statement shows when and
where the money was spent.
 Cash budget starts with cash on hand & bank and close with cash on hand & bank. A
cash flow statement starts with cash & cash equivalents and end with cash & cash
equivalents.

How the liquidity position of a company can be assessed? Describe the measures to assess
the liquidity position? M/J-16

Liquidity is the term used to describe how easy it is to convert assets to cash. The most liquid
asset, and what everything else is compared to, is cash.

In addition to forecasting and controlling working capital it is important that the business should
monitor its liquidity position on a regular basis. Two important measures that can be used to
assess the liquidity position are the current ratio and the quick (liquidity) ratio.

Current ratio

This ratio measures the ability to meet short-term liabilities from easily or quickly realisable
current assets.

It is calculated as follows.

Current ratio = Current assets / Current liabilities

A higher value for the ratio indicates that the business is more liquid and is able more easily to
meet its current liabilities from its available current assets.

Quick (liquidity) ratio

The nature of the inventory in some types of business means that it cannot be easily or quickly
converted into cash. This inventory cannot be relied upon as a liquid asset when it is
necessary to meet short term liabilities.

The quick ratio therefore excludes inventory from the current assets as follows.

Quick (liquidity) ratio = Current assets less inventories / Current liabilities

Managers who use a historical-cost accounting system look backward at what something
cost yesterday, instead of forward to what it will cost tomorrow.” Do you agree? Why?
N/D-16

There is some truth to this statement. However, using a historical cost accounting system with
budgets is not backward looking. Budgets force managers to plan for the future, including
predicting future prices.
 Chapter-8
What is feedback?

The term ‘feedback’ is used to describe both the process of reporting back control information to
management and the control information itself.

In a business organization, it is information produced from within the organization with the
purpose of helping management and other employees with control decisions.

The Elements in the control cycle:

Step 1: Pans and targets are set for the future

Step 2: Pans are put into operation

Step 3: Actual results are recorded and analyzed

Step 4: Information about actual results is fed back

Step 5: The feedback is used of management to compare

Step 6: By comparing actual and planned results, management can then do one of three things,
depending on howthey see the situation.

Effective feedback information should have the following features: N/D-13

1. Reports should be clear and comprehensive.

2. The 'exception principle' should be applied so that significant differences between the
target and the actual results are highlighted for investigation.
3. The controllable costs and revenues should be separately identified.
4. Reports should be produced on a regular basis to ensure that continual control is
exercised.
5. Reports should be made available to managers in a timely fashion
6. Information should be sufficiently accurate for the purpose intended.
7. Irrelevant detail should be excluded from the report.
8. Reports should be communicated to the manager who has responsibility and authority to
act on the information.

What is divisionalisation?

Divisionalization involves splitting the company into divisions, for example according to the
location or according to the product or service provided. Divisional managers are the given
authority to make decisions concerning the activities of their divisions.
What is decentralization?

In general, a divisional structure will lead to decentralization of the decision making process.
Divisional managers may have the freedom to set selling prices, choose suppliers, make output
decisions and so on.

What factors affecting the degree of decentralization?

 Management style
 The size of the organization
 The extent of activity diversification
 Effectiveness of communication
 The ability of management
 The speed of technological advancement
 The geography of location and the extent of local knowledge needed.

The advantages of decentralization:

 Senior managers are freed from detailed involvement in day to day operations
 The quality of decisions is likely to motivate
 The increased responsibility should motivate managers
 Decisions should be taken more quickly
 Valuable training grounds for future senior managers

The disadvantages of decentralization:

 It can be difficult to coordinate the activities of the organization

 Senior managers lose control over day to day activities
 They may be duplicating of some reels
 Evaluating the performance of managers and their area of responsibility becomes difficult
 There may be a duplication of some roles

Cost centres. N/D-10

A cost centre manager is responsible for, and has control over, the costs incurred in the cost
centre. The manager has no responsibility for earning revenues or for controlling the assets and
liabilities of the costs.

Revenue centres. N/D-10

In a revenue centre the manager is responsible only for raising revenue but has no responsibility
for forecasting or controlling costs.
Profit centres. N/D-10

A profit centre is a part of a business accountable for both costs and revenues.

Investment centres:

In a investment centre the amount of capital employed attributed to an investment centre should
consist only of directly attributable non-current assets and working capital.

General requirements for effective performance measures:

 They should promote goal congruence by providing an incentive to promote the

responsibility centre’s performance in line with overall company objectives
 The measures should incorporate only those factors over which the responsibility centre
manager has control
 They should encourage the pursuit of longer term objectives, as well as short-term,
budget-constrained objectives.

Potential problems with inappropriate performance measures

Problems that may arise through the use of inappropriate measures include the following.

 Managers may manipulate information in order to ensure achievement of the KPIs

 The measures might cause demotivation and stress-related conflict between a manager
and the manager's subordinates, superiors or fellow managers.
 The measures might promote excessive concern for the control of short-term costs,
possibly at the expense of longer term profitability
 They may lead to the assessment of a responsibility centre as an isolated unit, rather
than as an integral part of the whole organisation

Performance measures for a cost centre

Since the manager of a cost centre has responsibility for the costs incurred within the centre,
appropriate performance measures could be as follows.

 Cost variances, which are the differences between the budgeted or standard costs and the
actual costs
 Cost per unit
 Cost per employee
 Other non-financial measures such as the rate of labour turnover or staff absenteeism

Performance measures for a revenue centre

Appropriate performance measures would be related to the revenue earned.

  Revenue variances, which are the differences between the budgeted or standard revenue
and the actual revenue achieved
 Revenue earned per employee
 Percentage market share achieved
 Growth in revenu

Performance measures for a profit centre

Since the manager of a profit centre has responsibility for the revenue earned and the costs
incurred within the centre all of the above performance measures would be suitable. Additional
measures might include the following.

 Gross profit margin, which is the difference between the selling price and the direct costs
incurred, often expressed as a percentage of the selling price
 Operating profit margin, which is the gross profit less indirect costs incurred such as
administrative salaries, often expressed as a percentage of the selling price

Performance measures for an investment centre

All of the measures appropriate for a cost, revenue and profit centre would be suitable for
monitoring the performance of an investment centre. In addition, certain measures related to the
management of the investment in the division would also be useful. Such measures might
include a number of working capital ratios.

 Liquidity measures such as the current ratio and the quick (liquidity) ratio
 Rate of inventory turnover
 Receivables and payables periods

Two other measures monitor the return achieved in the division in relation to the level of
investment.

 Return on investment (ROI)

 Residual income (RI)

What is balanced scorecard?

The balanced scorecard approach to the provision of information focuses on four different
perspectives: customer, innovation and learning, financial and internal business.

Steps of balanced scorecard:

1. Identify the critical success factors for the business from four perspectives:

i. Financial perspective (survival, growth, cost reduction, asset utilization, risk)

ii. Customer perspective (time, quality, price, satisfaction)

iii. Innovation and learning perspective (employees, learning, products and services)

iv. Internal business perspective (the number or percentage of quality control rejects, the
average set-up time, the speed of producing management information)

2. Identify the core competence and resources required to achieve them

3. Develop the key performance indicators
4. Set targets
5. Monitor performance

Non-financial performance measures

It is important to realise that financial measures will only tell part of the story. To minimise the
risk of suboptimal decisions, a company should use as broad a range of measures as possible,
both quantitative and qualitative.

Other measures to consider could include:

 The number of new products developed

 The rate of employee turnover
 Customer praise/complaints
 The number of outstanding orders
 The number of warranty claims
 Health and safety incident statistics

Potential measures

A selection of potential measures is detailed below. These would obviously need adapting for the
circumstances of the individual company concerned.

 Financial perspective

Possible financial measures include:

 Survival, eg cash flows

 Growth, eg sales revenue
 Cost reduction, eg unit costs
 Asset utilisation, eg working capital ratios
 Risk, eg order books

 Customer perspective

Possible customer perspective measures include:

 Time, eg product delivery lead times

  Quality, eg defect rates
 Price, eg compared with the prices of competitors
 Satisfaction, eg repeat purchases

 Innovation and learning perspective

Possible measures include:

 Employees, eg the rate of staff turnover

 Learning, eg the number of days spent on staff training
 Products and services, eg the percentage of revenue generated by new products and
services

 Internal business perspective

Possible measures include:

 The number or percentage of quality control rejects

 The average set-up time
 The speed of producing management information

Problems:

As with all techniques, problems can arise when the balanced scorecard is applies:

1. Conflicting measures
2. Selecting measures
3. Expertise
4. Interpretation
5. Too many measures

Fixed Budget

A fixed budget is a budget which is set for a single activity level.

Flexible budgets: N/D-13

A flexible budget recognizes different cost behavior patterns and is designed to change as the
volume of activity changes.

A flexible budget has two advantages: N/D-13

1. At the planning stage, it may be helpful to know what the effect would be if the actual
outcome differs from the prediction.
 2. At the end of each month or year, actual results may be compared with the relevant
activity level in the flexible budget as control procedures.

Why have many managers in recent years moved toward emphasizing employee
participation in the budgeting process rather than simply imposing the budget on the
employees? M/J-14

Many managers believe that the quality of the budget is enhanched through employee
participation. There are a number of reasons behind this philosophy the principle one being
enhancement of morale and motivations of employees who feel empowered that they are a part
of the budgeting process and therefore owns the budgets. In addition, the budgets are more
realistic since they are based on information from the employees most familiar with the
department. As such, information asymmetry is reduced among several levels of management.
Coordinations between units is also improved.

Does a project that generates a positive internal rate of return also have a positive net
present value? Explain. M/J-14

No. A positive IRR does not necessarily mean that a project will also have a positive NPV. Only
if the IRR is greater than the discount rate that is used in the NPV calculation will the NPV be
positive

Define residual income. Evaluate residual income as a measure of performance. M/J-14

Residual income is determined by deducting from net operating income after tax a capital charge
on capital employed. This capital charge is the organizations’ cost of capital. The excess amount
adds value to the organization. This method can be used to assess the profitability of individual
assets or investments. A main advantage of using RI is that it overcomes some limitations of
ROI.

What are some common problems encountered in determining ROI ? M/J-14

Net income and investment involved can both be calculated several ways. Multiple calculations
are often presented to show the different factors that affect ROI, changes in sales, expenses and
capital investments.

Cost centers and profit centrs are usually associated with planning and control in
decentralized company-Explain. M/J-16

A cost centre manager is responsible for, and has control over, the costs incurred in the cost
centre. The manager has no responsibility for earning revenues or for controlling the assets and
liabilities of the costs.

A profit centre is a part of a business accountable for both costs and revenues.
In general, a divisional structure will lead to decentralization of the decision making process.
Divisional managers may have the freedom to set selling prices, choose suppliers, make output
decisions and so on.

A benefit of decentralization is having the decision makers closer to the markets in order to make
better and faster decisions.

Thus, Cost centers and profit centrs are usually associated with planning and control in
decentralized company.

What are some non-financial measures that a company might use in order to motivating
achieving the objective of anticipating future customer needs? N/D-16

Non-financial measures that a company might use in order to motivating achieving the objective
of anticipating future customer needs include:

 Time spent with key customers at targeted accounts learning about their future
opportunities and needs.
 The number of new projects launched based on customer input
 Macro economic indicators and industry growth forecast and
 Planned market share growth.

Standard costing can be used for control and performance measurment. Briefly describe
the types of control. M/J-17

Control is an essential features of any organizations which can be supported by management

accounting technique and information. In the context of Standard costing, variance analysis is
used to highlight differences between actual and standard costs to prompt correctives or reactive
action. Standard costing can also be used as a performance management tool as it provides
benchmarks and targets to assit the organization in determining if it is meeting its objectives.

There are three distinctive types of control:

1. Action or behavioral control: This involves observing or supervising actions of

individuals involved in production to ensure that quantity and quality of targets are met.
2. Personnel and cultural control: This involves establishing expected values, behaviors and
norms which are used to support achievement of targets.
3. Results or Output control: This involves collecting and reporting information on
outputs.This type of control is focused on quantitative information and can be most
closely related to managment accounting information produced.
 Chapter-9
What is standard costing?

Standard costing is defined by CIMA as a ‘control technique that reports variances by comparing
actual costs to pre-set standards so facilitating action

What are the functions of standard costing?

Standard costing involves the following:

 The establishment of predetermined estimates of the cost of products or services

 The collection of actual costs
 The comparison of actual costs with the predetermined estimates.

What is management by exception?

Management by exception is defined by CIMA as the ‘practice of concentrating on activities that

require attention and ignoring those which to be conforming to expectations.

Advantages of standard costing: N/D-11

 Carefully planned standards are an aid to more accurate budgeting

 Standard costs provide a yardstick against which actual costs can be measured
 Standard costs simply the process of bookkeeping in cost accounting, because they are
easier to use than LIFO, FIFO and weighted average costs
 Standard times simplify the process of production scheduling
 Standard performance levels might provide an incentive for individuals to achieve targets
for themselves at work
 The sitting of standards involves determined the most appropriate materials and methods.

Variances

A cost variance is defined by CIMA as 'the difference between a planned, budgeted, or standard
cost and the actual cost incurred. The same comparisons may be made for revenues.'

Variance analysis. N/D-10

Variance analysis is defined as the 'evaluation of performance by means of variances, whose

timely reporting should maximise the opportunity for managerial action'.

Material variances

The material total variance 'measures the difference between the standard material cost of the
output produced and the actual material cost incurred' (CIMA).
The material price variance

This is the difference between the standard cost and the actual cost for the actual quantity of
material used or purchased. In other words, it is the difference between what the material did cost
and what it should have cost.

The material usage variance

This is the difference between the standard quantity of materials that should have been used for
the number of units actually produced, and the actual quantity of materials used, valued at the
standard price per unit of material. In other words, it is the difference between how much
material should have been used and how much material was used, valued at standard price.

Labour total variance

The labour total variance measures the difference between the standard labour cost of the output
produced and the actual labour cost incurred.

The labour rate variance

This is similar to the material price variance. It is the difference between the standard cost and
the actual cost for the actual number of hours paid for. In other words, it is the difference
between what the actual labour used did cost and what it should have cost.

The labour efficiency variance

This is similar to the material usage variance. It is the difference between the hours that should
have been worked for the number of units actually produced, and the actual number of hours
worked, valued at the standard rate per hour.

Variable production overhead total variance

Variable production overhead total variance measures the difference between the variable
production overhead that should be used for actual output and the variable production overhead
actually used.

Variable production overhead expenditure variance

Variable production overhead expenditure variance measures the actual cost of any change from
the standard variable overhead rate per hour.

Variable production overhead efficiency variance

Variable production overhead efficiency variance is the standard variable production overhead
cost of any change from the standard level of efficiency.
Fixed overhead expenditure variance

Fixed overhead expenditure variance The fixed overhead expenditure variance is simply the
difference between the budgeted and actual fixed overhead expenditure in the period. By
definition, fixed overheads should remain the same, regardless of the volume of production and
sales. Any difference between budget and actual spending must be due to higher-than-expected
or lower-than-expected spending, and can have nothing to do with differences in volume of
activity.

The fixed overhead expenditure variance is (Budgeted fixed overhead cost – Actual fixed
overhead cost).

Sales price variance

The sales price variance is a measure of the effect on expected contribution of charging a
different selling price from the standard selling price. It is calculated as the difference between
what the sales revenue should have been for the actual quantity sold, and what it actually was.

Sales volume variance

The sales volume variance is the difference between the actual units sold and the budgeted
quantity, valued at the standard contribution per unit. In other words, it measures the increase or
decrease in standard contribution as a result of the sales volume being higher or lower than
budgeted.

“Overhead variances should be veiwed as interdependent rather than independent” M/J-16

Interdependence among the variances could arise for the spending and efficiency variances. For
example, if the chosen allocation base for the variable overhead efficiency variance is only one
of several cost drivers, the variable overhead spending variance will include the effect of the
other cost drivers. As a second example, interdependance can be induced when there are
misclassifications of costs as fixed when they are variable, and vice versa.

Briefly explain why a favorable spending variance on variable overhead may not always be
desirable. N/D-17

The variable overhead spending variance is the difference between the actual variable overhead
cost per unit of the cost-allocation base and the budgeted variable overhead cost per unit of the
cost-allocation base, multiplied by the actual quantity of the variable overhead cost-allocation
base used for the actual output. If a favorable variable overhead spending variance had been
obtained by the managers of the company purchasing low-priced, poor-quality indirect materials,
hired less talented supervisors, or performed less machine maintenance there could be negative
future consequences. The long-run prospects for the business may suffer as the company ends up
putting out a lower quality product, or it may end up having very large equipment repairs as a
result of cutting corners in the short term.
 Chapter-10
Breakeven analysis or cost-volume-profit (CVP) analysis. M/J-13

Breakeven analysis or cost-volume-profit (CVP) analysis is the study of the interrelationships

between costs, volume and profit at various levels of activity.

The contribution ratio

The contribution ratio is a measure of how much contribution is earned per CU1 of sales
revenue. It is usually expressed as a percentage.

Margin of safety. N/D-14, M/J-17

The margin of safety is the difference in units between the budgeted or expected sales volume
and the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales
volume. Alternatively the margin of safety can be expressed as the difference between the
budgeted sales revenue and breakeven sales revenue, expressed as a percentage of the budgeted
sales revenue.

What is a Break even chart?

A breakeven chart is a chart that indicates the profit or loss at different levels of sales volume
within a limited range.

A breakeven chart has the followings axes:

1. A horizontal axis showing the sales/output (in value or units)

2. A vertical axis showing CU for sales revenues and costs

Limitations of breakeven or CVP analysis and breakeven charts: N/D-12

It can only apply to a single product or a constant mix of a group of products

 A breakeven chart may be time-consuming to prepare

 It assumes fixed costs are constant at all levels of output
 It assumes that variable costs are the same per unit at all levels of output
 It assumes that sales prices are constant at all levels of output
 It assumes production and sales are the same (inventory levels are ignored – effectively
marginal costing is used)
 It ignores the uncertainty in the estimates of sales prices, fixed costs and variable cost per
unit.
Limiting factor. M/J-13, N/D-17

A limiting factor or key factor is 'anything which limits the activity of an entity'. An entity seeks
to optimise the benefit it obtains from the limiting factor. Examples are a shortage of supply of a
resource or a restriction on sales demand at a particular price.

An example is materials or labor.

How may a company overcome a limiting factor? N/D-17

To overcome a limiting factor a company may:

 Subcontract some of the works which cannot be carried out in-house due to the
constraints.
 Some lower level workers could be retained and they could then work on these products.
 A recruitment campaign could be launced and new workers could be sourced.
 Productivity and efficiency could be improved to reduce the time required per unit.

What is P/V ratio? How does it relate to the break-event point? N/D-11

P/V ratio is the relationship between the profit and sales. Profit volume ration can be called as
another term is contribution margin ratio. In formula it is expressed as P/V ratio= Contribution /
Sales * 100.

It is closely related to the breakeven analysis. For calculating the amount of breakeven sales, the
amount of fixed costs is divided by the P/V ratio.

Formula: Breakeven sales = Fixed cost / P/V ratio

Explain briefly, what are the underlying assuptions of CVP analysis? N/D-15

Suppose a company decided to automate a production line. Explain what effects this would
have on a company’s cost structure using CVP terminology. Could these changes have any
possible negative effect on the firm? N/D-17

An automated production line would increase fixed costs through extra depreciation on the new
machinery and also decrease variable costs.due to the elimination of direct labor as a result of
automation. This wourd increase the breakeven point Ths could possibly have a negative effect
on the firm if demand for the product produced by this production line is expected to decline in
the future. with high fixed costs and low demand, a decline in profit might be more sever due to
the presence of unchanging fixed cost as volume drops.
 Chapter-11
What are stages of investment decision making process?

A typical model for investment decision making has a number of distinct stages:

1. Origination of proposal
2. Project screening
3. Analysis and acceptance
4. Monitoring and review

The payback period. M/J-15

Payback is defined by CIMA as 'The time required for the cash inflows from a capital investment
project to equal the initial cash outflow(s).

Advantages of the payback method

The use of the payback method does have advantages, especially as an initial screening device.

 A long payback means capital is tied up

 Focus on early payback can enhance liquidity
 Investment risk is increased if payback is longer
 Shorter-term forecasts are likely to be more reliable
 The calculation is quick and simple
 Payback is an easily understood concept

What are disadvantages of payback period? M/J-15

There are a number of serious drawbacks to the payback method.

 It ignores the timing of cash flows within the payback period.

 It also ignores cash flows after end of the payback period and therefore total return of the
project.
 It ignores the time value of money.

There are also other disadvantages:

 It is unable to distinguish between projects with same payback period.

 The choice of cut-off payback period is arbitrary.
 It may lead to excessive investment in short-term projects.
 It takes account the risk of timing of cash flows but does not take account of the
variability of cash flows.
What is accounting rate of return (ARR) N/D-10

The accounting rate of return (ARR) expresses the average accounting profit as a percentage of
the capital outlay.

Capital outlay. N/D-10

The capital outlay may be expresses as the initial investment or as the average investment in the
project.

ARR = average annual accounting profit*100 / Initial investment

ARR = average annual accounting profit*100 /Average investment

Average investment is calculated as ½ (initial investment + final or scrape value)

Advantages of ARR:

 It is quick and simple to calculate

 It involves a familiar concept of a percentage return
 Accounting profit can be easily calculated from financial statements
 It looks at the entire project life
 It is a easily understood concept
 It allows more than one project to be compared

Disadvantages of ARR:

 It ignores the time value of money

 It takes no account of the length of the project
 It is based on accounting profits rather than cash flows, which are subject to a number of
different accounting policies
 It is a relative measure rather than an absolute measure and hence takes no account of the
size of the investment

What is net present value (NPV)?

The net present value of a project is the difference between its projected discounted cash inflows
and discounted cash outflows.

Advantages of NPV:

 It considers the time value of money

 It considers all relevant cash flows
 It provides clear decisions
 It is directly linked to the assumed objective of maximizing shareholders wealth
What are discounted cash flows. N/D-12

Discounted cash flows (DCF) techniques discount all the forecast cash flows of an investment
proposal to determine their present value

What is the net terminal value

The net terminal value is the cash surplus remaining at the end of a project after taking account
of interest and capital payments.

The NTV discounted at the cost of capital will give the NPV of the project.

Discounting

Discounting starts with the future value (a sum of money receivable or payable at a future date),
and converts the future value to a present value, which is the cash equivalent now of the future
value.

Advantages of DCF methods of appraisal. N/D-12

Taking account of the time value of money (by discounting) is one of the principal
advantages of the DCF appraisal method. Other advantages include the following.

 The method uses all cash flows relating to the project

 It allows for the timing of the cash flows
 There are universally accepted methods of calculating the NPV and IRR

What is annuity?

An annuity is a series of constant cash flows for a number of years.

What is the difference between NPV and NTV? [MJ10]

1. Net present value (NPV) pf a project is the difference between its projected discounted
cash inflows and discounted cash outflows. On the other hand, Net Terminal Value
(NTV) is the cash surplus remaining at the end of a project after taking account of interest
and capital payments.
2. NPV is the discounted cash surplus but NTV is the undiscounted cash surplus of a
project. Example NTV of a project is $ 6.035. NPV = $ 6.305 X 0.751 (10 % discount
factor for 3 years) = $ 4.532.

Discounted payback

The payback method can be combined with DCF to calculate a discounted payback period.
The discounted payback period (DPP) is the time it will take before a project's cumulative NPV
turns from being negative to being positive.

Advantage of Discounted payback

The approach has all the perceived advantages of the payback period method of investment
appraisal

 It has over traditional payback is that it has a clear accept-or-reject criterion.

 It is easy to understand and calculate, and it provides a focus on liquidity where this is
relevant. It also takes into account the time value of money.
 It therefore bridges the gap between the theoretically superior NPV method and the
regular payback period method.

Disadvantage of Discounted payback

DPP still shares one disadvantage with the payback period method: cash flows which occur after
the payback period are ignored

What is internal rate of return (IRR)

The internal rate of return (IRR) is the DCF rate of return that a project is expected to achieve. It
is the discount rate at which the NPV is zero.

Advantages of IRR method

 The main advantage is that the information it provides is more easily understood by
managers, especially non-financial managers.
 A discount rate does not have to be specified before the IRR can be calculated. A hurdle
discount rate is simply required which is then compared with the IRR.

Disadvantages of IRR method

 If managers were given information about both ARR and IRR, it might be easy to get
their relative meaning and significance mixed up.
 It ignores the relative size of investments.

In a net present value analysis, how can an analyst explicitly and formally consider the
influence of risk on the present value of certain cash flows? M/J-15

An analyst could do at least three different things to explicitly account for risk. The analyst
could:

1. Adjust the discount ratio to reflect the risk of the cash flow.
2. Adjust the discounting period of the cash flow.
3. Adjust the expected amount of the cash flow up or down to reflect the risk.
Why is the profitability index basis than net present value to compare projects that require
different levels of investment? M/J-15

The profitability index relates the magnitude of the net present value to the magnitude of the
initiaql investment. Thus, the PI gives some indication of relative profitability. The NPV itself
provides no direct indication of the level of investment that is required to generate the NPV and
therefore provides no indication of relative profitability. The PI is also very useful during
situations of capital rationing; projects with higher PI would get preferance over lower one and
capital allocation can be done accordingly.

What are the differences between Net present value (NPV) and Internal Rate of Return
(IRR). M/J-17

Distinguish between tax avoidance and tax evasion.N/D-16

Payback Period vs Net Present Value.N/D-15

Why Net present value is the Best Measure for Investment appraisal. N/D-17

Net present value method calculates the present value of the cash flows based on the opportunity
cost of capital and derives the value which wil be added to the wealth of the shareholders if that
project is undertaken.

There are many methods for investment appraisal such as accounting rate of return, payback
period (PBP), internal rate of return (IRR), and profitability Index(PI)

Let us discuss each of these methods in comparison with net present value NPV ro reach the
conclusion:

Net present Value (NPV) vs payback period

Payback period calculates a period within which the initial investment of the project is
recovered.

The criterion for acceptance or rejection is just a benchmark decided by the company. Therefore,
it does not consider the cash flows after the pay-back period and ignores time value of money.
Net present value considers the time value of money and also takes care of all the cash flows till
the end of life of the project

Net Present Value (NPV) vs. Internal Rate of Return (IRR)

lnternal rate of return (IRR) calculates a rate of return which is offered by the project irrespective
of the required rate of return and any other thing. It also has certain disadvantages like, it does
not understand economies of scale and cannot differentiate between two projects with same IRR

On the other hand, NPV talks in absolute terms and therefore this point is not missed.
Net Present Value (NPV) vs Profitability Index (PI)

Profitability index is a ratio between the discounted cash inflow to the initial cash outflow. It
presents a value which says how many times of the investment is the returns in the form of
discounted cash flows. The disadvantage associated with this method again is its relativity. A
project can have same profitability index with different investments and the vast difference in
absolute dollar return. NPV has an upper hand in this case.