Module 1: Intro

Accounting often perceived as extremely precise activity with rigid rules, but there are areas where
judgement has to be applied e.g. choice of the depreciation rate

Users of accounting info

● Internal:​ Senior executives, managers, employees etc.
○ Difficulty balancing the sharing of information
● External​: Shareholders, analysts, tax authorities, the public
○ Expectations on how money have been spent

The Accounting Equation

Owners’ equity = Assets - Liabilities
If inventory is sold for a profit for cash, then inventory decreases and cash increases. However, cash
increases by more than inventory decreases, resulting in an overall rise in assets. At the same time,
owners’ equity rises as the profit on the sale is recognised in the accounting records.

Types of companies
● Sole trader / Unlimited liability
○ Creditors ​can pursue owner beyond limit of business
○ Don’t have to make P/L and balance sheet public
○ Annual tax returns is a must
● Partnership
○ Partnership agreement​ sets out ​inter alia, how the annual profit will be shared
○ R​ules the same as for Unlimited liability as the partners personal assets are at risk
● Company
​ ○ Limited liability of the shareholders amount of equity (share capital)
○ C​ompanies must make public their annual accounts which must be audited by a
​ registered auditor, to protect creditors against abuse of the limited liability

A bit about profit

● Use ​Gross Profit​ (Sales - Cost of Sales) to measure ​efficiency​ of ​transformation /
production​ process.
● Use ​Net Profit​ (Gross Profit - Period & Indirect Costs) to measure overall ​management
efficiency​ against other periods
○ Net Profit before Interest Charges and Taxes
■ Most common measure of managerial efficiency.
○ Net Profit after Interest but before Taxes
■ Assess the financial structure by including the interest payment
 Module 2: The income statement (P&L)
Depicts all ​activities affecting owner’s equity in the balance sheet​ i.e. illustrates ​profitability

Measurement of Accomplishment
Accomplishment​ = No. of products ​shipped and invoiced

Accomplishment​ is measured at the first point in the process​ when:​

1. The product​ made and delivered​ against a firm order
2. All ​costs​ necessary to create the revenue have either
- been incurred​, ​can be predicted​ with acceptable degree of accuracy or ​are
negligible
3. Amount collectable in cash can be estimated​ within acceptable range of error
Other choices​ instead of ship and invoice:​
● Accomplishment when receiving an order
​ ​ ○ When ​interval
​ between order and shipment is ​short, ​goods are in ​inventory, major
​ costs have been incurred or ​cancellations are ​predictable
● Time of production
○ Only when producing to order, not in hope of getting one
● Time of collection
○ Used in markets where​ likelihood of receiving $$$ cannot be predicted accurately
○ High risk of reclaims because of non-​payment

Accounting Conventions
1. The realisation convention
a. Only products that ​have been sold are measured as sales
2. The accruals convention
a. An obligation made from creditworthy ​customer is good enough to act as sale
b. Also covers situation where customer pays invoice which covers a period beyond date
of financial statements

Measurement of Effort
Effort = direct costs + indirect costs

Accounting Conventions
1. Matching convention
a. All expenses must be matched in same accounting period as the revenues they helped
to earn
2. Allocation convention
a. Step 1:​ Determine how much of each component of production (in money terms) was
consumed in the accounting period.
i. Use of raw materials ​(Start + purchases) - End
ii. Labour - ​Use pay records
iii. Depreciation of fixed assets
b. Step 2:​ Decide how many of costs should be allocated to products unsold or unfinished
at the end of period
i. Cost of sales = (Beginning inventory + Purchases) - Ending inventory
3. Cost convention
a. Use the historical cost of means of production
i. Difficult if prices fluctuate during the accounting period
Depreciation methods
1. Straight-​line depreciation
a. Appropriate where:
i. Use of asset same each year
ii. Asset has equal decline in economic usefulness each period

2. Reducing balance depreciation

3. Consumption method
b. The greater the machine hours run, the greater is the wear and tear

Inventory valuation methods

Valuation of raw materials

Cost​ + ​conservatism​ (used if sell price < cost price to recognise losses and reductions in value when
they come to light)

Inventory costing methods

1. FIFO
a. Units left in inventory are ​valued at the latest prices
b. Drawback = ​rising prices gives high reported income, high taxes and high dividends
2. LIFO
a. Units left in inventory are ​valued at the oldest prices
b. Inventory used up by sales is ​replaced at the latest cost, best match of sales pricing
3. Average method
a. Weighted average unit cost during period applied to
i. Units sold to calculate good sold
ii. Units in ending inventory to calculate inventory value

It is possible to lower profit and minimise tax by switching between LIFO when prices are rising and
FIFO when prices are going down
Module 3: The balance sheet
Illustrates the ​financial position (valuation of assets & liabilities) o
​ f the company ​at given point
Comparing owner’s equity between two points will show how much profit / loss has been made.

Note that ASSETS can be described as:

- Untransformed​ – land, machinery, raw materials.
- Transformed​ – WIP, finished goods that have not yet been realised into P&L.
- When realised from inventory these become expenses.

Non-current Assets
● The​ Intention of Use​ that defines an asset as ​fixed or current​.
○ E.g. Cars: ​Current​ asset for a ​car dealer​, ​fixed​ asset for a ​driving instructor
1. Land
a. Not depreciated
b. Recorded at acquisition cost, together with legal fees and cost of preparing the land
c. Expenditure is written off u​ nless it is clearly related to the acquisition of asset and
the asset could not be made operational without incurring the cost
d. Alternative treatment to acquisition cost​:
i. Record acquisition cost and publish market value in parenthesis
ii. Revalue the asset from time to time, change book value and change the
shareholders’ equity (revaluation reserve) with the same value
2. Buildings
a. Often​ ​combined with land and shown as one amount in the balance sheet
3. Plant and Equipment
a. The faster the depreciation rate, the lower the profit in the P&L sheet (and book
value in balance sheet become)
4. Intangible assets
a. e.g. ​expanding IP and writing software
b. Companies are allowed to ​capitalise these expenditures (​ treat them as​ non-current
assets in the balance sheet)
c. Should be capable of being sold + have power to obtain future economic benefits,
otherwise it can be considered as routine expenditure
d. If the cost of the software had been significant in relation to the company (say £500),
then it would have been capitalised within non-current assets.
5. Lease
a. Why Lease?
i. Avoid substantial outflow of cash + spread the outflow into relatively small
amounts over the asset’s life.
ii. Maintenance costs are covered by the lease agreement.
iii. Lease payments can be charged against profits before tax.
b. Recording The Lease Activity
i. Operating leases​ (where ownership remains with the lessor) - record as
expense
ii. However recommended that​ leased assets​ are recorded under the terms of a
finance lease:​
1. Asset appears under fixed assets.
2. Future lease payments appears under creditors in the Liability section.
Current assets

1. Inventories
a. Value at whatever is lower between cost and realisable value (what it can be sold at)
2. Debtors
a. Conservatism: ​Some Debtors won’t pay.
b. Solution:​ Record an initial provision (based on previous experience). For following
periods, adjust the provision incrementally (managers decide the size of provision).
c. Matching:​ Ensure that costs and sales are recorded in the relevant period.
i. Debt is written off against profits in the period which debt is considered
irrecoverable
3. Cash
4. Prepayments
a. Paying for something that only needs to be paid next year is a current asset

Net Current Assets and Net Assets

● Net Current Assets:​ Current Liabilities – Current Assets
○ Generally shows ability to meet liquid commitments.
○ If current liabilities > net assets, then the figure is stated as ​net current liabilities
● Net assets:​ ​Net current assets + fixed assets
○ Used to look at trend of net assets over a number of accounting periods
Module 4: The Cash Flow Statement
Why Do We Need A Cash Flow Statement?
● To see ​liquidity​ of an org / it’s abilities to finance future operations + pay dividends / debts.

Sources of Cash
1. Profit from Operations
2. Capital Introduction
a. Injection of cash from owners normally at start of org.
b. Usually once off except if high growth and not enough cash
3. Creditors increase (​ owing the money, but can use it for other business purposes)
4. Debtors decrease ​(paying their bills)
5. Sale of Fixed Assets ​(total amount realised - costs of disposal used in Cash Flow Stmt)
6. Loans
7. Inventories decrease (​realises the money tied up in them)

Where does cash go to?

1. Loss from Operations
2. Capital repayments (​ buy own shares with spare cash, reducing capital base in the process)
3. Creditors decrease ​(Paying creditors)
4. Debtors increase ​(More customers buying on credit.)
5. Purchase of Fixed Assets
a. Maybe due to business growth, rapid technological change or existing assets becoming
inoperational.
6. Repayment of Loans
7. Inventories increase (​ consumes and ties up cash. Try JIT purchasing to free up cash)
Module 5: The framework for financial reporting
Reported profit​ will be​ ​directly​ influenced (a
​ nd can be​ open to abuse) by:
- Inventory valuation system​ used e.g. LIFO / FIFO
- How much ​overheads​ to ​allocate​ to inventory ​vs​ ​written off ​against this year’s profit
- Depreciation methods
- When revenue is recognised?​ At time of invoice or wait for payment?

Prevented​ by:
● Framework​ within which companies must operate in ​financial reporting
● Additional info that must be disclosed​ other than 3 familiar statements

Disclosing info
★ Companies often disclose the ​minimum information​ required, because of:
○ Potentially​ sensitive information.
○ Can ​cost money to prepare disclosure reports

Sources of Disclosure Requirements

1. Government Legislation
a. Legislation passed as ​Companies Act
b. Deal with ​WHAT​ must be disclosed
c. Independent ​Auditor​ must certify that the accounts give a ​true and fair view
2. IASB
a. Focuses on ​HOW​ the numbers are compiled.
b. Need to ​state whether standards have been followed (​ deviation allowed)
c. All companies on Stock Exchanges within the European Union must conform to IFRS
for annual reports and accounts.
3. Stock Exchange Requirements
a. Requires detailed ​info about the mgt. and financial structure​ of listed companies.
b. Requires ​1/2 year profit reports for shareholders​, must be disclosed in the press.
c. These ​extend the Companies Acts

Groups of Companies
- Holding company owning more than 50% in subsidiary companies must publish the
group P&L and Balance Sheet, plus it’s own Balance Sheet.
- No need to publish own P&L Sheet.
- Subsidiary companies continue to publish their own financial statements
- Subsidiaries whole assets and liabilities included in the group asset sheet (even if the
holding company doesn’t own 100% of the subsidiary).

Goodwill
❖ The ​excess paid for a share in a company, over the asking price
❖ Reflects the ​intangible asset​ not in the balance sheet (​good brand name, patents​ etc)
❖ Goodwill = Purchase Price – Company’s Net Assets.
❖ Add it to balance sheet e.g. pay 100 for company but assets is 50. Assign extra 50 to
goodwill under assets
Impairment Test
❖ Each cash generating unit to be tested for ​impairment (decrease) on annual basis
➢ Compare the carrying value (CV) of fixed assets and their recoverable amounts
➢ If the recoverable amount < CV, then impairment charge should be taken to the income
statement
❖ If goodwill figure not possible to allocate, explanation must be provided in notes

Deciphering the Report

Accounting policies and principles

● Refers to accounting bases selected and followed by the business
● Examples:
○ Consolidation​ – which subsidiaries are included? Some may be left out if they are so
small that they make no difference to the results.
○ Goodwill​ – value needs to be annually assessed and losses charged to P&L.
○ Accounting Policies​ – Depreciation policy of fixed assets.
○ Inventories​ – Valuation methods.
- Must be true and fair, externally audited and consistently applied on a year to year basis.

Consolidated Income statement

- IAS-14 : Requires info to be disclosed for both business & geographical segments.
- Distribution of Profits
- Minority Interest​ – Other Shareholders of the subsidiaries
- Preferred Shareholders ​– pay more per share, better dividends and more security
when company winds up.
- Ordinary Shareholders​ – pay less per share, no priority, higher risk if company fails.
- Material items
- Items that could individually or collectively distort the results.
- IAS1 – requires companies to disclose material items but ​unclear over whether these
should appear in P&L or the Notes.

Consolidated Balance Sheet

Two Items should be noted in the balance sheet
1. Minority Interest:
a. How much of the underlying subsidiaries are owned by minority shareholders.
2. Goodwill​ - IAS-35: Requires an annual impairment test

Share Capital
● The portion of a company’s equity obtained by trading stock to a shareholder
○ Authorised Share Capital:​ Total the organisation is allowed to issue.
○ Issued Share Capital:​ Total Share Capital allocated to Shareholders:
■ Treasury Shares - Held by the company itself (buyback).
Rounding
● Can round up to the nearest 100, 1000 or even 1000000!
○ Needs to be true and fair – not misleading + consistent in financial statement

Provisions, Contingent Liabilities and Contingent Assets

Provision
- = Liability as it is ​probable​ that outflow of cash will be req’d to settle obligation
Contingent liability
- A possible obligation that​ still has to be confirmed​ - hence no liability
- Or where ​reliable estimate cannot be made
- Contingent liabilities should not be recognised – but should be disclosed where an outflow of
economic resources is probable.
- Nature of contingent liability
- Estimate of financial effect
- Indication of uncertainness relating to timing and outflow

Contingent asset
- A contingent asset is a potential asset associated with a contingent gain
- Contingent assets should not be recognised – but should be disclosed where an inflow of
economic benefits is probable.

Providing for restructuring

To prevent excessive provisions IAS 37 requires that the company has
● A detailed​ formal plan for the restructuring​ defining the ​part​ of the business concerned,
locations affected​, ​number of empl compensated​ and ​when​ plan will be implemented
● Announced​ to ​those affected

Disclosure Requirements
Depreciation
● IAS-16 mentions basic methods (straight line, reducing balance + sum of units) as possibilities
○ Two overriding requirements for method selection:
■ Reflects ​pattern of consumption​ over the assets life.
■ Applied ​consistently​ from year to year.
● If the depreciation ​speeds up​ due to e.g. tech changes, ​management must adjust
depreciation equation accordingly and raise the depreciation charges.

Inventories
● IAS-2:
○ Inventories = ​Deferred cost​ in one reporting period carried forward to the next,
incurred on raw materials, WIP and finished goods
○ The more cost carried forward to next year = higher profits this year, hence regulated
● Valuation methods​ allowed include FIFO and weighted average (not LIFO).
○ Inventories must be measured at lowest of cost or realisable value
● Other potential inventory costs:
○ Storage and distribution​ (​added if part of production process​ (think whisky).
○ Admin​ costs ​NOT​ normally included.
○ Fixed production overheads is allowed if based on normal levels of activity.

Tips for reading financial statements

1. Amount of employees = ​Full Time Equivalents (FTE’s)
2. ”Proceeds from Borrowings”​ in Cash Flow statement = ​”new loans”
Fundamental Accounting Principles (IAS-1)
1. Fair Presentation
a. Financial Statements should fairly present the
i. Financial position (balance sheet), Financial performance (income statement)
and cash flows
b. U​se accounting policies that are relevant & reliable. ​Report departures from stds
2. Going Concern Principle
a. If management is aware of potential issues that could lead to the company being
unable to continue as a going concern, these should be disclosed.
3. Accrual Basis of Accounting
a. Income statement and balance sheet must be prepared on the bases that ​costs
incurred and benefits enjoyed are recorded, instead of cash paid or received
4. The Consistency Principle
a. Same accounting policies around depreciation and valuation.
b. Change is allowed,​ but only if the resulting picture better reflects reality or a new
standard has been established & previous years must be changed accordingly
5. Materiality, Aggregation and Offset
a. Materiality​ – how much omissions may change the picture (avoid high).
b. Aggregation​ – combining items in a single figure (only if similar).
c. Offset ​– do not deduct one figure from another and publish the net figure. Show both
6. Profit and Loss for a period
a. All items of income and expenses recognised in a period should be included in the P&L
statement for that period.

Management commentary
Companies must publish MC both on​:
- Financial statements in the annual report
- Discussion of strategic challenges faced by company in future

Headings defined by ISAB for MC:

1. Nature of business
2. Objectives & strategies (financial and non-financial) with timeframe
3. Key resources, risks & relationships
4. Results & prospects explaining development & performance of the company during the year
5. Performance measures and indicators to monitor progress towards objectives

Corporate Social Responsibility (CSR)

A ​voluntary​ disclosure to report things such as:
● Emissions​ of harmful waste in atmosphere
● Harmful substances​ in production
● Marketing strategies to vulnerable sectors​ such as children
Due to lack of rules, ​companies only discloses topics to show them in favourable light

The external auditor

- Independent, qualified professionals
- Protected from dismissal by a vindictive management
- Reports on the quality of the financial report.
Internal Control
- Internal Control​: measures taken by mgt to control employees
- If good IC present, the auditor can rely on the system to produce adequate records.
- One way of determining IC:
- Draw flowchart of systems, roles & responsibilities to highlight weaknesses in system:
- Too much power vs lack of control in a certain area.
- Level of Materiality​: Auditors set limit in monetary terms, below which they won’t examine in
depth. This is set by the Auditor, probably based on the level of IC.

The Audit Report

I. Examination of the system of bookkeeping
II. Comparison of the balance sheet and P&L with underlying records.
III. Verification of the assets in the balance sheet.
IV. Verification of the liabilities in the balance sheet.
V. Verification that the results shown by the P&L are fairly stated.
VI. Verification that Group accounts give true and fair view of company and subsidiaries
VII. Confirm that statutory req’s been complied with and standards have been applied

Auditors also ​state whether or not​:

● They received all the information they required.
● Proper accounts have been kept.
● Proper & adequate returns have been received from branches or subsidiaries not visited.
● The accounts are in agreement with the books.

Qualified report = Auditor found problems & provides reasons. ​Unqualified report = No problems.
Module 6: Interpretation of Financial Statements
Why Ratio Analysis
1. Easy comparison​ - Use industry average stats for benchmarking
2. Good for spotting trends ​-​ ​Not so good taken in isolation

Warning about Ratios

- Used to suppress poor figures
- Year end figures may not reflect typical position of company
- Calculate ratios at different points of the year.
- Definitions may vary across the industry ​e.g. capital employed
- Consistency therefore important.

Liquidity Ratios – Short Term Survival

● > 2 sound financial situation. Companies with ratio of less than 2 may well be able to pay their
bills - especially if large proportion of assets = cash

● > 1 Quick Ratio means no matter how great the losses incurred on sales of inventories,
company will still have enough money to pay obligations
● If quick ratio bad but current ratio matches avg, the amount of inventory may be the problem

Profitability Ratios - Long term survival

Measure management’s ​overall effectiveness

Use Profit From Ordinary Activities Before Taxation

- Basically Profit before Tax (and interest)
- Tax liabilities distort figures as they often reflect accruals from earlier accounting periods

● Margin needs to be high to bear the burden of corporate overheads.

● Large diff btwn gross profit margin and profit margin indicates heavy overhead structure

● If low ratio, consider shedding unproductive assets.

 ● Capital Employed = (Total Assets – Current Liabilities) OR
● Capital Employed = (owners’ equity + non-current liabilities)
● Indicates how many resources are locked up in the business and working for shareholders and
providers of loan & debt.

● Use net profit (this is after tax)

● Often seen as positive if this is high, but can indicate that the company relies heavily on debt.
● If bad return, share price falls & make future chances lower. ​If profit declines, equity does too!

Capital Structure Ratios

Two types:

1. Examines asset structure of the company

● If significant investment in non-current assets has to be maintained, further investigation

might focus on whether leasing or other finance arrangements could reduce the cash
tied up in non-current assets.

2. Analyse the ​financing arrangements of the company.

a. A high ratio often indicates that business has been aggressive in financing via debt.
This can be an issue due to interest expenses, especially in volatile economic times.
b. High gearing (higher debt): Less risk of loss when market goes into recession, but lower
returns when things take off.
c. Low gearing (higher equity): More risk of loss when market goes into recession, but
higher returns when things take off.
d. Example:
i. If debt is 52% of owners’ equity, debt = £1484m (52% of £2854m).
ii. If owners’ equity increases to £3354m as a result of the rights issue, then the
revised debt/equity gearing ratio is £1484m/£3354m, or 44%

● Ability to pay interest (higher = better cover)

Efficiency Ratios - how effectively a company manages its assets

❖ If Cost of Sales not available, use raw material and labour components.
❖ Higher the better
❖ Tip – 52 / times to get the number of weeks holding

❖ Trade receivables = Debtors

❖ Length of time a company must wait for cash after making a sale.
❖ AKA ​Days Sales Outstanding

❖ Good to see how non-current assets relate to revenues.

❖ Further investigation might focus on whether leasing or other finance arrangements could
reduce the cash tied up in non-current assets.

Window dressing
● Attempt to make results look better than they really are
● Fraudulent agreement between parties e.g.
○ Company sells £200and then buyer returns it after the end of the financial year.
○ Can lead to auditor marking the accounts as not being “true and fair”.
○ Ratio analysis can be carried out throughout the year to identify window dressing

The Dupont Chart

➢ Based on Return on Total Assets (ROTA), most significant ratio:
100% Statement
➔ Revenue set as 100%.
◆ Each item of cost is calculated as a percentage of sales.

Basic Stock Market Ratios

❏ Shareholders want to see that EPS grows over time.

❏ High PE shows that market thinks there is potential - willing to pay more

❏ Dividend return based on today's market value of the share.

❏ Many countries company is obliged to pay tax on dividend before payed to shareholder,
therefore gross dividend yield sometimes calculated

❏ What if management pay out too high dividends to keep shareholders happy
❏ This ratio will draw attention to such practices.
❏ Higher = generally better.
❏ Sharp increase – pulling money out?
Module 7: How to understand a bank’s annual financial statements
Income statement

● Dividend income​ - income the bank receives from various equity stakes it has taken in
customers
● Net trading income ​- foreign exchange; currency, derivatives; government and
non-government fixed income and money market instruments;
● Other operating income ​- comprises rental income on the leasing of assets; gains on disposal
of property, plant and equipment; and valuation gains on investment properties
● Loan impairments and other credit risk provisions ​- equivalent to bad debt provision.

Balance sheet
Other info
Risk-weighted assets

Tier 1 capital = equity + retained earnings / risk-weighted assets

For example, bank ABC has $600,000 in equity and retained earnings and has $10 million in
risk-weighted assets. Its tier 1 capital ratio is 6% ($600000/$10 million), which meets the minimum Basel
III requirement.

Ratio Analysis

Profitability

➔ Interest per asset. Smaller == charging less interest per asset

➔ Upward trend over a number of years == the bank has improved its bottom-line profit (e.g. less
competition in pricing loans or an improved bad debt experience)

Gearing

➔ Below a certain minimum, supervisors insist that either no further borrowing is done by the bank
or that it raises more Tier 1 capital to support growth in the lending book. We use the
risk-weighted assets because this figure represents the total view of risk the bank is running.

➔ A rising trend in this figure should raise questions about the bank’s continuing ability to take on
new lending business without injecting more equity capital.
 ➔ A falling trend would suggest that the bank is becoming more and more successful in attracting
customer deposits, traditionally seen as a cheap form of funding, as opposed to raising money
from more expensive and riskier sources.

➔ The stock market likes to see a rising trend in absolute dividends paid, but if this is achieved
only by distributing a higher and higher percentage of a shrinking earnings figure = not good

Operations

➔ A rising trend in this ratio would indicate the increasing reliance on non-core banking activities.

= 0.335%
➔ A rising trend in this ratio, however, would cause analysts to question the risk profile of the loan
book being taken on.

➔ A downward trend in this ratio would reveal an increasingly efficient bank.

Highlights and Key Topics in the Industry

1. Deposits are more important / cheaper than short-term borrowing
2. Banks add mortgage loans and securities to their product range to manage interest risk and to
use the surplus of inexpensive deposits,
3. Consumer lending is mostly to homeowners
4. Bigger doesn’t necessarily mean more efficient
5. Conflict between banking and accounting regulators - banking regulators are happier with more
conservative (i.e. bigger!) amounts to cover unforeseen risks.
6. When fears about bad debts increase, banks start to worry about lending to other banks and the
inter-bank market can freeze up
Module 8: Introduction to cost and management accounting
Mgt accounting​ provides ​information​ to ppl ​within an org​ while ​financial accounting​ is mainly for
those ​outside​ e.g. shareholders. ​Financial accounting​ is required by ​law

Mgt accounting is based on current and future trends​, which does not allow for exact numbers.

Financial accounting is precise and must adhere to Generally Accepted Accounting Principles (GAAP),
but mgt accounting is often more of a guess or estimate, since most managers do not have time for
exact numbers when a decision needs to be made.

Mgt accounting gives information on:

❖ Actual & projected ​cost​ and prices of ​individual products & departments
❖ Projected​ sources and uses of cash
❖ Proposals for major investment
Module 9: Cost Characteristics and Behaviour
Why do mgt need ​cost​ information?
1. Plan​ ​next year's costs​, based on lessons learnt from previous years.
2. Control​ – take corrective action if necessary.
3. Track​ ​consumption of resources​ to evaluate ​efficiency​.
4. Choose​ among​ alternative courses of action.
5. Determine​ a desirable ​selling price.

Where do costs come from

1. Materials
a. Differences that arise between actual purchase price and std price are accounted as
price variance in the income statement
2. Labour
a. Time spent on job * pay rate
b. Standard wage rate is used as operatives probably have different wages
i. The cost also includes social security, taxes and pension contributions
3. Overheads
● Manufacturing overheads
● Factory Heating and lighting
● Depreciation on saws, lathes.
● Rent and rates for the workshop.
● Salaries of foremen, inspectors and production management team.
a. Non-manufacturing overheads
● Office heating and lighting
● Depreciation on office equipment, computers and motor vehicles.
● Rent and rates for the office and showroom.
● Salaries of office staff and general management.

Variable Cost
➔ Costs ​varies with volume​ produced
E.g. labour costs / material
Fixed Cost
➔ Does NOT change when amount of items change
E.g. admin costs / depreciation

Combining Variable & Fixed Costs

- Think cell phone charges
- Preferred approach is to ​split these type of charges into their constituent parts

Direct / Prime / Traceable costs

➢ Physically traced to each cost Item.
➢ Just materials and labour, ​no overhead.
Indirect / Common costs
➢ Unable to trace directly to each item ​i.e overhead
➢ E.g. Heating, lighting
Product costs
- Raw material, labour ​+​ ​manufacturing overhead​ (can be traced directly to production)
- Those ​product costs ​which ​can’t be allocated t​ o any category of ​inventory​ are ​charged
against sales revenue as ​cost of sales
Period costs
- Costs incurred in ​support​ of the product
- E.g. selling, general admin costs, marketing

The way company classifies costs into product and period costs affect profit figure:
The more product costs, the higher inventory valuation and higher reported profit.

Of course all costs are theoretically ​controllable​ but generally ​uncontrollable costs​ can be defined by
those that cannot easily be changed. For example building rent is a fixed cost that the owner/manager
has little control over on a monthly basis.

Standard​ ​costs​– Budgeted Costs, based on studies and recent experience.

Actual​ ​costs ​– Measured period by period

Engineered costs (like product costs)

● Costs engineered into product like materials, direct labour etc.
Discretionary costs (like period costs)
● Can reduce the spending level relatively quickly if needed. Down to managerial discretion

Break Even Chart

Margin of Safety:​ Difference between Break Even and actual output

Profit Volume Ratio
Measures the impact of volume on profit.

The higher the result, the higher the contribution the sale of a unit makes.

Example:
0.4 = $4 profit / $10 sales (For each $1 of sales, we earn a contribution of 40 cents).
0.5 = $5 / $10 (For each $1 of sales, we earn a contribution of 50 cents). Preferable to the above.

Calculating Break Even Point

❖ Equation Method

➢ E.g. X = 100 000 + 0,6Y => break-even at 250 000 units

❖ Contribution Margin Method

➢ Contribution margin = Sales revenue per unit – Variable cost

❖ Contribution Margin Ratio Method

➢ Contribution Margin Ratio = Contribution margin per unit / Sales revenue

Limiting Factors of Production

Objective of company could be to maximise contribution
- Can have constraints like availability of space, machine hours, skilled labour etc.
- Mgt must identify limiting factors and calculate contribution margin per unit of limiting factor

Assumptions of Cost-Volume-Profit Analysis

1. All costs can be identified as variable or fixed
a. Not as easy, think semi variable costs
2. All costs are standard
a. Fixed costs may fluctuate e.g. reaching certain volume capacity may require more
machines
b. Variable costs may also fluctuate e.g. higher at start of production
3. Sales price per unit remains unchanged
a. Company may alter price to reflect changing market conditions or volume orders
4. Sales mix will be maintained as budgeted
a. Sales mix will change
5. All production is sold - ​In reality unsold items are retained in inventory
Module 10: Allocating Costs to Jobs and Processes
Used to spread overhead across the units of production

Activity base / Casual Factors

- Find that that causes the majority of overhead i.e. activity base / casual factor
- Examples:​ Sales, Personnel (No. of employees), Computing (Service Hours), Site maintenance
(Sqm used)

Plantwide versus Departmental Rates

● Plantwide Rates
○ Formulated for 1) one-product firm or 2) more than one-product using 1 activity base.
● Departmental Rates
○ Allocate Overheads to different departments
○ Transfer ​service department overheads to ​production departments so they can be
attached to products

Departmental Rates: Direct Method

1. Find relevant activity base for each service department
2. Proportionally​ split the​ relevant activity base​ ​between​ the ​production​ ​departments

Doesn’t consider the interrelationships between service departments. Recognised by step method

Departmental Rates: Step Method

Two Choices:
1. Select service departments in ​descending magnitude of overhead spend
2. Select ​department that renders highest % of its total services to other service
departments
In the above example we are using choice 1:
1. Find a relevant activity base for each service department
2. Add up the total activity base - contribution of the service department to be reallocated
3. Reallocate costs to all the other departments proportionally
4. Move to next department and do same (closed departments removed from further allocation)

Joint Products
- Product that ​appears during process of producing the main product
- e.g.​ aircraft fuel, then also sell raw chemicals
- If there’s an option of whether or not to create 2nd product then the 2 products aren’t joint

Joint Products: How should the production cost be split?

1. Equal Shares ​- split cost into two.
2. Physical Characteristics
a. Split cost proportionally based on some physical characteristic ​e.g. weight
3. Sales Value at Split-Off
a. Split cost proportionally based on sales value
b. For example:
i. Prod1 - $80000 Sales Value (62% % of Cost).
ii. Prod2 $50000 Sales Value (38% of Cost).
4. Ultimate Net Sales Value
a. Split costs proportionally based on the final sales value e.g. after further processing
b. The new costs should be included in the calculation.

Why split the production costs?

● Product Management
● Inventory Valuation

By-products
● Differ from joint products in terms of motive and commercial value
● Has a low sales value relative to the main product e.g. Ends and trimmings.
● Emerges from a production process that is designed to produce another product. e.g. afval

● Only the revenue from the actual by-products ​sold​ can be deducted
● Unsold are carried forward in inventory at ​zero cost

Job Costing vs Process Costing

Job Costing:
❖ Individual products seen as ​individual jobs which incur ​separate costs
❖ Products are physically separable and costs can be traced to each one
➢ e.g custom designed piece of furniture.
Process Costing:
❖ Used in industries where products are not uniquely identifiable and process is almost continuous
like chemical industry, brewing industry etc. e.g. 1000 gallons of oil
 Job costing Process costing

Uniqueness Unique products Standardised products

Size of job Small Large

Record keeping More required since time & Less record keeping because of
materials charged to specific aggregated costs
job.

Customer billing Used for billing customers

Process Costing: Equivalent Units

Converts partially completed units into equivalent whole units
● Completed 12 litres paint where 4 were WIP and 50% completed at the beginning of the year
● Equivalent units = 10 + 4 x 0,5 = 12 is used to divide in total cost of production to determine the
cost per equivalent unit

Cost Per Equivalent Unit

➔ Weighted Average Technique
◆ Costs of opening WIP and current period production are merely added together
◆ Better at smoothing out seasonal fluctuations. May mask other fluctuations.
Activity Based Costing
★ 100 burgers, 100 lemonades. Electric power bill $200. How to split?
★ Traditional splits equally​ - $1 each product
★ ABC splits based on proportional consumption of each activity
★ What if 3W for burger, 1W for lemonade? Charge more against burger
★ ABC involves all overhead costs such as R&D, quality control, marketing

Traditional Costing weaknesses

1. With traditional costing, companies don’t tend to change allocation bases, once it’s settled
2. Traditional costing drastically overstates High-Volume Products
a. This difference could lead to incorrect strategic decisions, for example:
i. ”Lets introduce more Low Volume Products, as they are cheap to produce”.
ii. ”Lets increase the Price of High Volume Products to cover more of our costs”.
b. Products with low resource consumption are often asked to bear higher costs than they
deserve and vice versa.

Time Driven Activity-Based Costing

● ABC is sometimes seen as too much work, and doesn’t capture complexity of operations.
● Some businesses are using Time Driven ABC which requires two estimates:
○ Cost per time unit of supplying resource capacity.
○ Unit times of consumption of resource capacity by products, services and customers.
● In other words use time as the unit
Module 11: Costs for decision making
Absorption vs. Variable Costing
Limited to manufacturing costs only​ (exclude distribution, admin etc.)

Absorption (full costing):

● Each unit is asked to​ absorb it’s own share of overheads
Variable (direct costing):
- Only​ variable costs may be included within the inventory valuation
​
- Accounts for ​overheads as a fixed lump sum charge.

➔ When production > sales

◆ Absorption costing reports higher profits but the costs will have to be accounted for at
some point!
◆ I.e. more fixed costs get parked in inventory
➔ When production < sales
◆ Variable costing reports higher profits, because absorption costing now results in:
● Unsold items (and their costs) are realised from inventory.
● More costs being applied results in lower profits.

The difference between the two is simply a question of the timing of fixed costs.
Note that at the end of the day the profit profiles will be identical for both methods.

Denominator Volume Variance (DVV) for Absorption Costing

The denominator volume variances are caused by actual production levels differing
from the planned production levels.

16K should be debited to P&L as DVV

Analytical Framework For Non-Routine Decisions
Not everyday choices. Rather things like ”Shall we shut down the department”?
It is essential that mgt construct a framework within which ‘one-off’ decisions can be analysed in a
thoroughly disciplined manner.

1. Define the problem and list alternatives

2. Cost the alternatives
a. Relevant costs:​ Only costs that DIFFER amongst alternatives are important
b. The pitfalls of absorption costing
i. Keeping fixed costs seperate makes it easier to interpret them ​(or even
remove them from consideration unless they differ between the options).
c. Opportunity costs
i. Try to quantify opportunity costs
1. e.g. let’s say a semi-automated solution has the opportunity to loan
out labour to competitors 3 months a year at income of 240

d. Sunk Costs should be ignored when looking for relevant costs

3. Assess the qualitative factors ​e.g. relationship with workforce.
4. Make the Decision
Module 12: Budgeting
Pros
1. Coordination
a. Coordinating activities within the same org e.g. whether the aspirations of the sales
team can be realised by the production department
2. Planning
a. A detailed plan sets out targets for the entire org
3. Motivation
a. Each person in the org has a target to shoot at, which, provided it has been set within
achievable limits, will provide a personal motivation throughout the period.
4. Control
a. Provides a benchmark to measure performance against
b. After a careful analysis the next budget can be adjusted to be tough but achievable

Cons
1. Time
a. Budget process often starts too early > Start as late as possible.
b. Time consuming
2. Lack of mgt commitment
a. Budget holders get frustrated when they see senior mgt wasting money
3. Form of punishment
a. Often all discretionary expenditure such as entertaining and travel are stripped out
4. Responsibilities are blurred
a. Mgt get annoyed when they have to manage costs that they have no control over (i.e.
corporate level).
5. Moving goalposts
a. Implement a rolling budget – 12 months view of the future
6. Budgeting towards inefficiency
a. Blanket budgeting (expenditures that are authorized on a blanket basis, without
specifying individual projects, allowing for slackness) can unfair to those who are good
at holding budgets

Typical Sequence of Preparing a Budget

Commence with the business forecast of what can be ​sold​ and work through the impact on ​production
capability to ​purchasing​ requirements.

Reasons why discretionary expenditure is hard to budget

1. The principal difficulty surrounds the ​measurement of output​. What is the output of an R&D
lab, for instance?
2. Some discretionary outputs are best measured negatively (we learn from failed experiments)
3. Budget holders are not always sure of corporate objectives
4. Not always easy to control on annual basis (i.e. R&D programs that run over multiple years).
5. Many feel that there is a lot of slack in discretionary budgets, so people get jealous
a. ZBB to the rescue?
Zero Base Budgeting (ZBB)
● Mgt invites certain activities to ​bid for resources ​as if they were starting from scratch (a ZB).
○ Activities are analyzed and split into packages of work.
○ Packages are are costed, then ranked in order of priority.
● Decisions made by top management.
● New requests for increased spending take priority over existing commitments.
● Drawbacks:
1. Splitting up activities into costing packages is difficult, costly & time consuming
2. The definition of the packages is often left to managers of the functions under review
a. May be presented in a way that ensure the status quo is maintained (fixing the
game)

Cash Budgets

Do not include depreciation!

Module 13: Standard costing
Standard Costs = Budgeted Costs for individual cost items

Budgeting Material usage

❖ Best indicator: Last year's consumption per unit
❖ For new products, an engineering study may be commissioned
➢ Ideal Standard:
■ If all aspects of production run at maximum efficiency.
➢ Normal Standard:
■ Normal inefficiencies factored in.

Budgeting Material price

❏ Best indicator: Suppliers rates (discounts, bulk), market forces, external market events
❏ Where prices fluctuate a lot = reduce budget period

Budgeting Labour usage & price standard

➔ Measure labour time required including breaks
➔ Set in a similar manner to materials (via engineering study)
◆ Include any anticipated uplift of wages during the budget period

Budgeting Overhead standards

★ Standards for variable and fixed overhead ​depend​ upon
○ Budgeted cost of each overhead.
○ Allocation key to be used when allocating cost to products.
○ The volume expected of each allocation key (unit, labour hours and so on)
★ For example, assume overhead = $100 000 for next year and the allocation key to be used is
machine-hours for all fixed overhead. If 40 000 machine-hours is anticipated next year, a
budgeted fixed overhead rate of $2.50 per machine-hour will be used. A product that uses 10
machine-hours will have a standard fixed overhead rate of $25.00 for next year.

Flexible (Flexed) budgets

Variances
Is the variance favourable or adverse?

● Material Efficiency variance

○ (Std quantity - actual quantity) * ​std​ price per unit
○ Causes:
■ Staff inexperience, faulty material, bad equipment -> higher waste
● Material Price variance
○ (Std price - actual price) * ​actual​ quantity
○ Causes:
■ Change of supplier, quantity discounts, market forces
● Labour Efficiency variance
○ (Std time allowed - time taken) * ​std ​rate per hour
○ Causes:
■ Staff inexperience, faulty material, faulty equipment
● Labour Rate variance
○ (Std rate per hour - actual rate per hour) * ​actual​ time taken
○ Causes:
■ Lower caliber of staff - more time, less overtime paid than budgeted for, no
causal link with labour efficiency
■ Higher-grade labour will be more expensive, giving rise to an adverse labour
rate variance.

- Variances should be calculated where they arise and passed on to the next department at std cost
- Consistent variances may indicate that the standard / budget needs to be recalculated.

Variable Overhead Analysis (VOH analysis)

Use total amounts, not unit / hour
❖ Simple variance
➢ Std cost - actual cost
Did we use less or more money on VOH than expected?
Combines the next two variances
❖ Efficiency variance
➢ Std cost of budgeted time - Std cost of actual time taken
■ if time is allocation key
❖ Spending variance
➢ Actual cost - (Actual hours x Std cost per hour)
Fixed Overhead Analysis
➔ Spending variance
◆ Budgeted fixed overheads - actual cost stated
● Budgeted fixed overheads e.g. (year budget / 12)
◆ If the overhead cost applied to WIP is more than the overhead cost actually incurred
during a period, the difference is known as overapplied overhead
● The outcome is that there is a credit in income statement, reflecting the
over-recovery of overheads. The normal accounting treatment for such an item
is to include it as a reduction to cost of goods sold, since cost of goods sold will
include an overhead element based on the (incorrect) predetermined overhead
allocation rate.
● If there is an under-application of overheads, it means that actual overheads
have exceeded applied overheads. If the applied overheads are £178 000 and
under-application is £22 000 the actual overheads are £200 000
➔ Denominator variance
◆ Budgeted fixed overheads - (actual time taken * std cost per hour)
● Budgeted fixed overheads e.g. (year budget / 12)
Did we spend less / more money on actual time used for production than budgeted?

Sales Variances
Mgt need insight into consequences of not achieving the sales ​volume​ & ​mix​ planned for the budget.
Contribution = Selling price - variable costs per unit

Volume variance
➢ (Actual sold - planned sold) * planned price

Sales volume contribution variance

➢ (Actual sold - planned sold) * Standard Contribution/unit

Sales price variance

➢ (Actual price - planned price) * actual sold
Module 14: Divisions
Advantages for Divisions
★ Specialisation of skills
★ Size of workforce ​-​ ​Smaller groups, smaller / localised problems.
★ Motivation ​- Feeling of ownership leads to motivation.
★ Sharper Decisions ​- Managers are closer to the problem and responds quicker
★ Career Mobility ​- Divisions can be a testing ground for managerial talent

Disadvantages for Divisions

● Central management loses control
● Cost ​- Duplication of essential administration staff
● Empire building and playing politics

Types of Divisions
❖ Cost Centres ​- Responsible for costs only (not revenues)
e.g. a division that is bottom part of a production chain
❖ Revenue Centres ​- Responsible for generating revenues (without reference to costs)
e.g. the seat reservation system of an airline.
➢ Focus on revenue generation regardless of associated costs (which are mostly fixed)
❖ Profit Centres ​- Cost & revenues matched (Traditional)
➢ Performance assessed via bottom line profit
❖ Investment Centres ​- Consider net assets when evaluating profit performance

Return on Investment (ROI)

ROI = Net Profit / Investment in net assets​ e.g. 8m / 60m = 13.3%

If ROI needs to be e.g. 16% and the extra profit on a project is 100K, then the amount acceptable to
invest is 100K/16% = 625K

Residual Income
Alternative, better view than ROI
Residual Income = Profit - (investment in net assets * imputed interest)
● 58m = 100m - (350m * 0.12)

Requirements:
1. Imputed interest/ cost of capital must be constant, otherwise it will lead to friction
2. Valuation of the asset base is key

The current profit level is 320K. Interest is 6%. Investment is 2M. Residual income is 200K.
- If an asset is scrapped for 100K, then the imputed interest charge falls to 114K from 120K (6%
of 1.9M), altering residual income to 206K. The difference between 206 K and a target of 182 K
is 24 K of ‘extra interest’. At a 6% cost of capital, this equates to an extra investment of 400K
(24K/0.06).
Asset Base Valuation
1. Net Book Value = Acquisition cost - accumulated depreciation
a. Results in a growing ROI over time.

b. This is the std approach

2. Replacement Cost
○ e.g. by looking at suppliers catalogues
○ So the ​current value is used​ as opposed to the historical depreciated cost.
○ But the ​subjectivity​ of this approach prevents many companies from using it

Transfer pricing
Divisions may wish / require to trade with one another:
- Danger of political games​ My division sells at an inflated cost = my figures look better, even
though the company doesn’t earn money on the sale
- Market Prices
★ Best alternative for transferring goods & service btwn divisions, because it can be
objectively​ ​tested by both parties.
Use suppliers price lists, market observations in a truly competitive market etc.
- Cost Based Prices
❖ Full costs: B ​ ased on variable costs plus fixed costs. But then the buying division are
contributing to the fixed costs of the selling division!
❖ Variable Costs:​ Just using the variable costs means that the buying division are
getting the product cheap and are being subsidised by the selling division!
❖ Negotiated Costs: O ​ ften used when managers can’t agree and upper management
force them to propose a solution that will not harm the company! I.e. Dual Pricing.

International Divisions Taxation

Also, by adjusting transfer prices one can ensure that profits are repatriated e.g.
- Country 1 restricts division from sending it’s funds (through cash transfer or dividends) back to
the country of the main company
- The division located in the Country 1 pays high transfer prices to a division located in the
country of the main company.
Module 15: Investment Decisions
Capex: Investment decision:​ Impact extends ​beyond the current operating period​ (i.e. Year).
Opex: Operating decision:​ Impact ​within the current operating period​.

Investment Decisions
● Investment = Increases Capital employed
● Return on Capital Ratio will decrease, requiring higher profit targets
● Also consider the opportunity cost of investment in one project over another
● The further we go into the future, the more uncertain business becomes.

The Investment Process

1. Search - ​Identifying investment opportunities.
a. Accounting generally has little to offer here, but may identify areas for improvement
e.g. in the case of growing material waste
2. Evaluation - ​Is the investment worthwhile?
a. The most important concept is that of PV
b. In addition the business needs to consider where it is, where it wants to go and it’s
strengths and weaknesses.
3. Control - ​Monitor actual income and outgoing and compare this with budget.
a. Project Budget ​- for major items like installation of expensive new equipment.
b. Capital Budget​ - for a period showing the capital to be expended
i. Important input to strategic planning and cash planning

Present Value
Considers time value of money
- Known as ​discounted cash flow approach​ to​ evaluate investment opportunities

NPV
● Take project cash flows and reduce them to a common denominator (PV) by using an
appropriate interest rate (i.e. cost of capital)

IRR, also Discounted Cash Flow (DCF) Rate of Return

● Find the interest rate which reduces all cash flows to zero i.e. the rate of return at which the
project will break even

NPV = absolute, IRR = relative. Perhaps both analyses should be performed to get real picture!

Not-for-Profit Situations
❖ Use NPV and apply cost minimisation (i.e. choose option where the NPV is lowest negative).
Risk and Uncertainty
1. Do no further analysis
a. Mgt looks at figures & makes decision, taking account of all other factors felt relevant
2. Mgt groups projects into risk categories
a. Use higher rate of return on more risky projects
3. Payback​ answer the question ‘When will we get our money back?’
a. Disadvantage​: It ignores relevant cash inflows ​after the point of payback
b. Also ​ignores the opportunity cost of capital​ invested
c. Better method is to ​reduce the cash flows to their present value b ​ efore deducting
them from the original investment

Sensitivity Analysis
➢ Analysis on ​what happens if things change
➢ Involves c
​ hanging critical key variables to assess how this affects the final result
○ i.e.: selling prices, sale quantities, or adjust cash inflow
➢ Doesn’t​ take into account ​probability​ of taking place. ​Risk analysis caters for this!

Risk Analysis
● Subjective probability for deviations from an estimate.
● Take range of outcomes + probability of occurring & find the mean

Key Investment Factors

Investment appraisal techniques highlight the key investment factors that are central to the profitability of
an investment

Capital investment
● It is not only the amount that is important, of course, but also the timing
○ Fixed Capital
■ Cash outflows to cost of ​new buildings and equipment.​
■ Cash inflows from ​government tax allowances and grants​.
○ Working Capital
■ Cash outflows as​ debtors build up
■ Cash inflows from ​debtors pay back
Operating cash flows
❏ Cash flows generated in operating period
❏ Inflows arise from ​sales​ vs outflows from ​operating expenses
❏ Non-cash expenses like depreciation have no part in the calculations
❏ Looks at profitability of a project over its lifetime, not only the accounting year

Investment life
❖ Factors determining the lifetime of the investment
➢ Physical​ – wear and tear or fatigue may cause the asset to collapse
➢ Technical​ – asset is obsolete because of new technology
➢ Market​ – product may no longer be demanded
❖ Don’t use depreciation calculations for deciding the investment life of a specific project.

Cost of capital
➢ Key factor in assessing the profitability of a project
How a business might determine its cost of capital:

Projected Average Cost of Capital

● Cost of capital is regarded as the ​average cost of various sources
○ Fixed interest loans i.e. long term securities i.e. debentures
■ Cost of Capital = (int rate + service cost) x (1 – tax rate)
○ Fixed interest shares (i.e. type of preference share)
■ Cost of Capital = (int rate or dividend + service cost)
○ Ordinary shares
■ No predetermined rate, so assume = ​the lowest return that shares are
currently earning
○ Retained earnings
■ Funds generated internally not distributed, so assume ​funds should earn the
same as the existing investment

Weighted average cost of capital

After estimating costs of the various sources of long-term finance, ​work out an average cost based
on the relative proportions that are expected to be used.

Inflation
➔ Real value of money (purchasing power) changes over time because of inflation
➔ Independant from time value of money.
➔ Inflation difficult to predict and is rarely straight line.
◆ Use sensitivity analysis to help analyse this variable.
Module 16: Techniques under Development in Management Accounting
Shortcomings of current Management Accounting
1. Driven by ​financial accounting​ (​focus on inventory valuation and profit measurement).
2. Direct labor​ still a popular method of ​overhead​ allocation, even though it’s use is shrinking
3. Automation​ is challenging established ​boundaries fixed and variable costs
4. Complexity of business has increased – ​more product lines, shorter life cycles, more
product support needed.
5. Globalization​ accentuates many of the above problems.

Target Costing
The ​leader’s​ ​price​ ​sets the benchmark​ beyond which imitators ​dare not go​. Most suited in
fast-moving technology-based goods markets, where there are innovative competitors and where market
sizes and selling prices are known.

❖ Suits ​innovative industries​ where new products often released.

❖ Not an alternative to standard costing, but necessary in a ​consumer driven market
❖ Improving costs to m​ eet the target cost benchmark​ is known as ​value engineering
➢ Focuses on direct manufacturing costs and support overheads
➢ A promising area for​ cost reduction​ is often the design phase
■ Fewer features
■ Made from ​cheaper raw materials
■ More robust design (​lower lifetime costs)​

Step 1- Determine Target Cost

➔ Target Cost = Market Price - Profit Margin

Step 2 – Derive and Improve Manufacturing Cost

➔ Identify potential savings
◆ An internal examination of costs.
◆ An external request to suppliers to improve their prices.

Step 3 – Derive and Improve Manufacturing Cost

➔ Addition rounds of ID’ing potential savings to further close the gap between​ Improved
manufacturing cost a​ nd ​Target Cost

Life Cycle Costing

Not focused on a financial period, but the lifetime of the product
★ Lifecycle income statement (for all products) over 3 years.
○ From conception (R&D) to EOL (spare parts, support competence, documentation).
■ Minimize R&D normally results in rise in repairs and complaints
■ Large investment in R&D might not give value if doubt on market potential after
a couple of years
Throughput Accounting
● Requires the ​identification of the bottleneck in the production process​ e.g. Only 200
machine hours available.

Throughput Accounting Ratio

● Total Factory Cost = Direct Labor Costs + Total Manufacturing Overhead
The Balanced Scorecard
● Measuring company’s health using 4 perspectives - list goals and measure success
● Attempts to ​make up for the narrow-minded cost focused accountancy view​.
● Includes financial measures​ giving the results of actions taken.
● Also includes operational measures​ on critical concerns such as customer satisfaction,
quality, product / process innovation and ability of the workforce to adopt smarter work habits.

Customers: How do customers see us?

Goals: Get to market faster
Metrics: On time delivery rates

Internal Business Processes: What must we excel at?

Goals: New designs, QoS, speed of response, staff on time, time since last incident (safety standards)
Metrics: Operational measures

Innovation and Learning: ​Be better at acquiring, storing, transmitting knowledge in the workforce.

Financial: How do our shareholders regard us? f

Goal: To survive and grow
Metric: Product line gross margins and volume variances.

Possible to add additional areas i.e. environmental measures – impact on environment