REVIEW

Chapter 1
The fundamentals of costing

Phuong Thao NGUYEN

NEU - SAA
 MI- 33 questions

Costing & pricing 1 scenario-based

25% 1- 5 question (20%)
Ethics

Budgeting & forecasting 25% 6-7 Multiple-choice

Multi-part
Performance management 25% PT9 multiple choice
Multiple-
Management
25% to
-41
response
Decision-making
 1. Definitions
Original cost accounting: establish

+ Inventory valuation + Profit/loss + Balance sheet items

Chap I 5

Management accounting: provide information to help management

+ planning + control + decision making

Chap 8,9 Chap to .tt
Cost accounting system: provide the foundations for an
organization’s internal financial information systems

➔ Establish inventory valuation ➔ Planning

➔ Control ➔ Decision-making
 2. Basic concepts
-

Doi
twang coin tink cost
Cost object: anything for which we are trying to ascertain the cost

(a unit of product/ service/ a department/ a function/ a project…

Bo .
ph.in
Cost centre: any part of an organization that incurs costs
ctohioingco.ba
'

D-in vi. n

Cost unit: basic measure of on a particular cost object

(product/ service)

Composite cost unit: cost unit made up of 2 parts

U) : Ho c
.
phil sink vién his
 3. Cost classification
For inventory valuation & profit
measurement ➔ Prime cost = total direct costs
➔ Direct/ indirect material
➔ Overhead = total indirect costs
➔ Direct/ indirect labour
➔ Direct/ indirect other expenses
➔ 1 Relevant range
For decision making
➔ Fixed cost
➔ Variable cost mixed cost
For Control: ➔ Semi- variable costs
➔ Controllable costs ➔ Dangerous: extrapolation
➔ Uncontrollable costs

E cost unit
Khi unit :

FC constant
VC constant
SM
 4. Ethics
Management information
➔ Clear
➔ Accurate & complete
➔ Prepared on a timely basis
5 Fundamental principles
Threats
➔ Integrity
➔ Familiarity
➔ Objectivity
➔ Self-review
➔ Professional competence &
➔ Self – interest
due care
➔ Intimidation
➔ Confidentiality
➔ Advocacy
➔ Professional behaviour
 REVIEW

Chapter 2
Calculating unit costs (1)

Phuong Thao NGUYEN

NEU - SAA
 Total cost

Direct costs Indirect costs

Direct material Indirect material

Direct labour Indirect labour

Direct expenses Indirect expenses

 Material cost
Component parts Negligible amount/cost
Or
purchased for a particular
product, service, job….
-

Packaging tru.itiipitintayhha.ch Going

nhu'
'

bainh
Packing cases
vo

Primary packing materials

. . .

(cartons/ boxes) di chu yin choi din tag

'

≤
Ding .
. . .

hhaihhanqnhu.ie chi Going

Direct materials Indirect materials
 Labour cost

Wages paid for direct labour:
= Total hour x basic pay
➔ Total hour: basic hour + overtime
Wages paid for indirect labour
Premium pay for overtime
(unless for a specific cost unit)

Payment for idle time

Direct Labour Indirect Labour

 Other
expenses

Expenses
➔ Cannot be traced in full to
Expenses
➔ incurred on a specific cost unit a specific cost unit
(Rent/ insurance/ depreciation…)

Direct expenses Indirect expenses

 2. Inventory valuation

FIFO
Infographics
Pricing LIFO
methods
Cumulative
AVCO
Infographics

Periodic
Different profit - temporary
Inequalities even out – long run
 REVIEW

Chapter 3
Calculating unit costs (2)

Phuong Thao NGUYEN

NEU - SAA
 Standard costing

Inventory valuation
Costing method
(calculate unit cost)

Absorption costing Specific order costing

➔ Traditional (job/batch/contract)
➔ ABC
Continuous operation
Marginal costing
costing
(Process costing)
1. Absorption costing Overhead expenses
1. Allocate
2. Apportion

Direct Indirect Non-production

production costs production costs overheads
1. Allocate
2. Apportion
Production Service
Allocated cost centre Re apportion cost centre
directly

3. Absorption of overhead 3 stages:

- Allocation
Full Production cost per cost unit
- Apportion
=direct costs+ share of indirect costs
- Absorption
 Stage 1. Overhead allocation
Charged directly

{
A production department
factory
A production service
department
Cost
Overhead An administrative
centres department
A selling/ distribution
department
Collecting place
An overhead cost centre
 Stage 2. Overhead apportionment
Step 1 Step 2
1. Apportion production department 1
general overheads
to cost centres bo.pha.in sin xuiit

production department 2

Overhead Service cost

Re apportion

centres U3 : bio tri ,

canteen .
. . .

That allocated to
general overhead Administration, selling
cost centres
and distribution 2. Re-apportion the cost of
service centres to production
department departments
 1.3. Overhead apportionment – step 1
Apportionment bases
Basis Overhead
Floor area Rent, rates
(m2) heating & lighting
repairs and depreciation of buildings
Cost/ book value of Depreciation
equipment Insurance
No. employee Personnel office, canteen,
Labour hour welfare, wages and costs offices, first aid
Volume of space Heating
(m3) Lighting I
hhainhauchiiucaomu.ccti.ch
 1.3. Overhead apportionment – step 2
Re-apportionment bases

Service cost centre Example of possible bases of apportionment

Stores Number of material requisitions
Maintenance Hours of maintenance work done for each cost
centre
Production planning Direct labour hours worked in each production cost
centre
 1.4. Overhead absorption (overhead recovery)

Production Production Sales

overheads overheads
Allocated Absorpted
Total cost of sales 8000
Full production
cost per unit cost

I
Under/ over absorption
Selling/ administration/
distribution costs
Inventories Predetermined absorption rate
➔Blanket absorption rate
➔Departmental absorption rate Profit/ Loss

Direct materials 5
Goin
}
:

g- -
labour 2 , I =
/ unit
overhead 3 " "

Six : woo units I

 1.4. Overhead absorption (overhead recovery)
NOTE

Budgeted overhead Actual overhead

4

Budgeted activity Rate = Actual activity

Absorbed overhead
% budgeted overhead
Budgeted activity
②
Over/under absorption:
= rate x actual activity = actual overhead –
absorbed overhead

Type of question:
• Determine one of the above missing information → time to 2

→ lift ki 4 yeii to
"
→ tin coin friend
2) Activity -
based costing -
ABC
uoi traditional
→ upgrade
.

Traditional

\ % !! "y :*
ABC
-
labour near " "

phu-ho.to phat and do Chi phi set

thuiongotgsuidl.mg
Ichi OVH up
-

↳ ↳ .

.
ain
,
drain:c out
,
mi or "
→
Gip chung out
,
chi ai 1 rate
to 1 rate
ring
- Phair bio
'

d-in → to drink ✗ad .

 REVIEW
i
Chapter 4
Marginal costing

Phuong Thao NGUYEN

NEU - SAA
Di
'

sx thin sin phaii chi pha't ahh ve

AC Fc dia arai wstlunit
f
:

[ P2 think nhan fixed cost

VMC : Fc to diea vat cost / unit

Marginal costing
costing system to absorption costing

Variable
Variable Variable Fixed
production
materials labour costs
overhead

I
Marginal Period
production costs
cost

Charged in full against

Valuation of units the sales revenue for
-the period
 1. Marginal costing
µ
Chixuiithii.ir troy
Contribution Selling price Total Marginal Cost
↳ = MC + FC + profit
Contribution towards fixed overheads and profit

Total contribution = Contribution/unit x Units sold

Expected profit = Total contribution – Total fixed costs

2. Marginal costing & Absorption costing

Marginal costing Absorption costing

C) Chia then variable , fixed cost G Chia ra direct -
indirect oté xii Y
'
.

▪ Closing inventory: valued at ▪ Inventory valuation: full Production

marginal (variable) production cost cost – include fixed production costs
1 phai toy tire
▪ Fixed cost: ▪ Cost of sales:{
+

phaiiky-na-yduiabaiph.at
-
I

- Charged in full against profit of - Include: some fixed overhead

current period incurred in a previous period
- NOT include in the inventory - Exclude: some fixed overhead
valuation do , liquor try
'
incurred in this period
sink ky-niw-tiihua.by
bad drink left
ty was →
2. Marginal costing & Absorption costing
Marginal costing Absorption costing

Sales X Sales X
Cost of sales (X) Cost of sales (X)
(Variable costs) (Full production costs)
Contribution X Gross profit X
-

Fixed costs (X) Non-production costs (X)

Net profit X Net profit X
 2. Marginal costing & Absorption costing

Inventory levels Effect on the reported profit

Closing inventory > Opening inventory AC profit > MC profit

I ::::::
bad hit
'

↳ Sx K0 Cao
hoi
profit
.

Closing inventory < Opening inventory AC profit < MC profit ① maintain OI, CI .

↳ bald? ca
'
has toi tho

Closing inventory = Opening inventory AC profit = MC profit

↳ sx bad = .

think t.ch do OVH troy sp

MC profit = AC profit +(-) (CI - OI) x fixed Production overhead/ unit
Neil du bad
'

units soo
SX 1000
-

AC

/
Mc
-2 OVH -1-1000 -
woo
-

soo
bain hit
Difference in profit
IN
-
Neil profit Me =
profit the - 200
Ac ↳ units

)
Mc =
soo ✗ 1
-
too - woo

→ profit nluinhan
 REVIEW

Chapter 5
Pricing calculations

Phuong Thao NGUYEN

NEU - SAA
 1. Pricing calculation
Chapters 4

f)
,

Sales price Cost Profit

Full costs / Absorb time wst

Mark – up: = PTof

- Production cost
Profit = a% x cost
- Production cost + non-production cost

Marginal costs

- Variable production cost

Margin: =
1↓÷a=L?¥→wm
Profit = b% x price
- Variable Production cost + Variable
non-production cost
 Method of transfer pricing :b air noir bio
.

'

✓D: chi phi tiép thi , .

. .
.

Market price
as the tieiikiei.in
'
thi truong Cai chi phi
Iaij gia
-

: .

nhiai ng bah , ng
-

hoar hat
-

mua
frank
:

D-K :[thi .
thio-ngca.us
full capacity

to st-protit-T.de iioc tink trc

Cost-plus price
.

≈ '
'

bah
DK:S p Chi w I ng
'

cty
ctywwdeiiphaimuanguyeiolie.io
me
'
.

't
✓ D: to .ca ta
ca

troiithueiba-y-caihdaiycaogoauguyailie.ir
:

↳ lakh wait -

to
bad cat
.

↳
Fixed

2 part transfer price ✗ variable

(2 part tariff) nhua.is % → ✓ D: <
A: 30%
to %
n Phair Chia toy : too B :

decision
/→ doin doin hi.in thong
'
sub optional .

Dual pricing
-

A B
VD :
cost 4

÷/
cost

f-
"

www.qgIIIIIE.scenerio-basedamuT
contribution

full cost
selling
→
rice :b
toil nguo-u-h.ie , th / g → sells price g
REVIEW

Chapter 6
Budgeting

Phuong Thao NGUYEN

NEU - SAA
 du.ci vai principle budget
di quiet drink
'

factor
1. budgets be:p budget nño
[
tree

Functional budgets Budget for 0

sales
→
(Department budgets)
Amend many time before O
Budget for production
prepare master budgets
O
Budget for purchase

Budget forO
labour
Master budgets
Before the start of O
Budget for administration

period

tieii
Budgeted income Budgeted Cash → auantro.mg _

again
statement balance sheet budget
 2. Functional budgets

Sales budget: Sale units = expected revenue/ expected price

Production budget:

Budgeted production
otéphonghong
= Forecast sales + Damages/deterioration/loss + CI of FG – OI of FG
↳ Sale units .
 2. Functional budgets

Material usage budget:

= Budgeted production units x material/unit

Material Purchases budget:

= Material usage budget + Damages/deterioration/loss + CI - OI

Labour budget:

= Number of labour hours x rate/hour

 3. The master budgets
Budgeted income statement
Sales X
Cost of sales
Opening inventory X
Raw materials X
Direct labour X
Production overhead X (X)
Gross profit X
Administration, S&D (X)
Budgeted profit X
 3. The master budgets
Budgeted balance sheet
Non-current assets X
Current assets
Inventory X
Receivables X
Cash X X
Current liability (X)
Net current asset = X
CA - CL
Owner’s capital X
 3. The master budgets
The cash Month1 Month2
Estimated Receipts
budget
Receipts from receivables
From cash sales…..
Payments
Payments to payables
Expenses…
Net surplus (deficit)
Opening cash balance
Closing cash balance

→ fun va-ova-ohirale.ch ra bao nhiiw

 the hip chi *Ét cai thang
tip their toting budget
→ cat thang gain ,

[ Sau lip Chung chung

3. The master budgets
The cash Month1 Month2
Estimated Receipts
budget
Receipts from receivables
From cash sales…..
Payments
Payments to payables
Expenses…
Net surplus (deficit)
Opening cash balance
Closing cash balance
 •heme

①
✗

:"!s
✗d- diaii volume

thiip nhiit , aw nhaii 4. Forecasting technique

Techniques

1. The High-low method

hair lick tuyen tink
p

2. Linear regression analysis

3. Correlation

4. Time series analysis

 High-low method

Period: Highest volume of activity ➔Total variable costs

• Step 1 = Difference in total costs of
Period: Lowest volume of activity these 2 periods

𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠

• Step 2 The variable cost/unit =
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑙𝑒𝑣𝑒𝑙𝑠

• Step 3 Fixed cost = substitution

• Step 4 Linear equation y: total cost a: Fixed cost

y = a + bx x: level of activity b: variable cost/unit
 5. Big data
The 4 V’s of Big data
1. Volume ➔ scale of data
2. Velocity ➔ timeliness
3. Variety ➔ structure or unstructured data
4. Veracity ➔ challenge to keep information clean/ unbias
- -

Problems of big data

1. Lack of forecasting tool
2. Privacy
3. Security
4. Incorrect data
5. Lack of skilled data analysts
 6. Other approaches & structures
Alternative approaches
1. Incremental budgeting duh cho hain
→va-onaintrcla.is nay

2. Participation budgeting → do top manager tip -

Cho Cai khoaiochitieieaiaohinhphu.my

3. Zero-budgeting
""
(1) > ⑤ < hi→du.org
4. Rolling budget → 12 thang VD master budget
.
:

Alternative structures
1. Product-based budgets tip chodoauknghi.ipion-sp.vn
→
Samsung

2. Responsibility – based budgets Chia Ñ controllable

→
vé to table
union

3. Activity – based budgets → dei.ava-ocaihoa.to?iyphatsinhchiphilABc

)

4. Rolling budget
-
7. Data bias & professional cepticism

Type of bias

1. Selection bias → dei bien d? hi choir population 'd

a → to da.idiei.is cho
ng thi

Self-selection doiti.ongd.ch?acho.uw'traloiohayk-chiotiaitrad?N
-
,

2. →

nhain drink kieiiva-odieiitra-saile.ch

3. Observer bias kiai
' '

otia y →
ca ,

4. Omitted variable trong dieu tra

bi sit thong :
tin
based
that's that phu.ci ding ten -

nhin
5. Cognitive lhiei.eu ) aiitio.ngva-ocaidoiit.in
→
.

"
ng
mi neo :

cat thong tin ≠

6. Confirmation
ainguinieiin.tw too ,
,
qua

7. Survivorship tech trong dei dive

Kai nghiin cake
: la :
chiing khoaei chi pr ring thank wing ti
.

→
moi too
VD : nghiiu cool cat yeii to think wing c.)

ing tha't
'

bqi
-

so
qua → Sai
n
.
 REVIEW

Chapter 7
Working capital

Phuong Thao NGUYEN

NEU - SAA
 1. Working captial

Working capital = Total current assets – current liabilities

= Receivables + inventory + cash - Payables
 2. Ratios
Inventory
trbhtknain.sk ho bao bin

Inventory Inventory
= x 365
turnover period Cost of sales

'
cia htk
si ring quay
Rate of Inventory Cost of sales
=
turnover Average inventory
↳ caigtha-pcang.to 't
 2. Ratios
Receivables
Receivables
Average receivables
collection period = x 365
(in days) Annual sales revenue
Credit sale

How long on average it takes to collect debts

The collection period in:
• Month: x 12 (instead of 365)
• Day: x 365
 2. Ratios
Payables tlgiautuikhiwuiahingoteiihhitrauhokbo.in
Payables payment Average payables
= x 365
period (in days) Annual P𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
= ¥10T OI

How long on average the company delays paying its suppliers

The collection period in:
• Month: x 12 (instead of 365)
• Day: x 365
 2. Ratios
Liquidity position

Current Current assets

=
ratio Current liabilities

Quick Current assets − inventory

=
ratio Current liabilities
 ratio d-ahh
2 catch
'

operating cycle gig

-
→
\ cash
3. The cash operating cycle
Purchases Sales
Inventory days
Work in Finished
Raw material progress goods
Receivable days

Payable
s days

Cash operating cycle

Cash Payment Cash collection

Length of cycle = RM + WIP + FG + RC - PP

Raw materials holding Annual Inventory of raw materials
period (RM) = x 365
Annual usage
Average production Average Inventory of WIP
= x 365
period (WIP) Annual Cost of sales

Average inventory Average inventory of finished goods

= x 365
holding period (FG) Annual Cost of sales

Average receivables Average receivables

= x 365
collection period (RC) Annual sales revenue

Average payables Average trade payables

= x 365
payment period (PP) Annual Purchases
 4. Control systems
Inventory Control systems
Re-order level system Fall to predetermined level ➔ Order
fixed quantity
Periodic review system
=
Review at fixed time interval ➔ order
variable quantities
ABC system Classify inventory: A, B, C

Economic order quantity C = cost per order

system (EOQ) D = estimated usage / demand 𝟐𝒄𝒅
H = holding cost EOQ =
𝒉

Just in time Production & purchasing link closely to

sales demand – week to week basis
Perpetual inventory Update and record: each receipt and issue
methods
 4. Control systems
Manage Trade Payables

Manage Trade Receivables

chip
'

- Discounting tai
- sai thi
- Factoring bin duit
-

Treasury management
- Short-term finance
- Invest surplus funds
 Cash budgets

• Estimated cash receipts X

chi tiein
(X) this Sui
=

• Estimated cash payments

1- deep charge)

• Net surplus/ deficit X

• Opening cash balance X
• Closing cash balance X
 REVIEW

Chapter 8
Performance evaluation

Phuong Thao NGUYEN

NEU - SAA
 1. Feedback Input
Feedback loop resources

1
2
Plan, Operation
target or compare 5
Compare 6
Control
budget actual results
action
with plan

Outputs
3 (actual
4 Measure output,
Feedback of outputs revenue,
information cost)
 2. The behavior impact of performance measurement

Budget Ability to meet budget

constrained on short-term

Style of Ability to increase

evaluation Profit conscious general effectiveness
➔ long - term

Budgetary information
Non- accounting ➔ relative unimportant
part in evaluation
 3. Responsibility accounting

Decentralisation of authority

Cost centre

Revenue centre System of

Responsibility
responsibility
centres accounting
Profit centre

Investment centre
 3. Responsibility accounting

Appropriate
measures
 3. Responsibility accounting

Controllable divisional profit

ROI = X 100%
Divisional capital employed

RI = Centre’s profits – notional (imputed) interest

cost of the capital invested in the centre
 4. The balanced scored card approach
1. Identify the critical
Financial perspective
success factors 2. Core competences and
resources to achieve

Internal business
Customer perspective 4. Set perspective
target

Innovation & Learning perspective

5. Monitor
3. Key performance performance
indicators
 5. Budgetary control
Step 1: determine cost behavior patterns
• Fixed costs
Preparation
of flexible • Non-fixed costs
budgets ➔ Variable cost:
➔ Semi – variable cost:

Step 2: Calculate the budget cost allowance for each cost item
Budgeted cost allowance
= budgeted fixed cost + (No. of units x variable cost/unit)
 5. Budgetary control

Variance: The difference between the budget and the actual results
• Favorable variance (F) : higher profit
(higher sales revenue or lower costs)

• Adverse variance (A): lower profit

(lower sales or higher cost)
 REVIEW

Chapter 9
Standard costing & variance analysis

Phuong Thao NGUYEN

NEU - SAA
 1. Standard costing
Standard costing:
• Control technique
• Reports variances = actual costs ≠ pre-set standards
• Facilitate action by exception

➔Comparison: actual costs with predetermined estimates

(at the same level of activity)
 1. Standard costing

Standard cost per unit:

• The usage of resources (6kg per unit; 5 hour per unit…)
• The price per unit of resources (£5/kg, £10/hour…)

➔ Use to prepare a budget

 2. Variances

Material price variance = (SP – AP) x AQ

Material
variances
Material usage variance = (SQ - AQ) x SP

Total material variance = SP x SQ – AP x AQ

= (SP – AP) x AQ + (SQ - AQ) x SP
= Material price variance + material usage variance
 2. Variances
Material variances

Material price variance = (SP – AP) x AQ

• Closing inventories of raw material valued at standard cost (1,000 x 3)

AQ: material purchases in the period

• Closing inventories of raw material valued at actual cost (FIFO) (1,000 x 3.1)

AQ: material used in the production in the period

 2. Variances

Labour rate variance = (SR – AR) x AH

Labour
variances
Labour efficiency variance = (SH - AH) x SR

Total labour variance = SR x SH – AR x AH

= (SR – AR) x AH + (SH - AH) x SR
= Labour rate variance + Labour efficiency variance
 2. Variances

Variable VO expenditure variance = (SR – AR) x AH

production
overhead
variances VO efficiency variance = (SH - AH) x SR

VO total variance = SR x SH – AR x AH
= (SR – AR) x AH + (SH - AH) x SR
 2. Variances

Fixed production overhead variances

Fixed overhead expenditure variance

= Budgeted fixed overhead – actual fixed overhead
 2. Variances
Sales variances

Sales price variance = (AP – SP) x AQ

Sales volume variance = (AQ – BQ) x SC

SC: standard contribution per unit

3. Operating statement
 REVIEW
Chapter 10
Breakeven analysis
& limiting factor analysis

Phuong Thao NGUYEN

NEU - SAA
 1. Break even analysis

Breakeven point = Number of units of sale required to break even

Total fixed costs

=
Contribution per unit

Contribution required to break𝑒𝑣𝑒𝑛

=
Contribution per unit

Margin of safety = Budgeted sales volume - breakeven sales volume

 1. Break even analysis

Contribution ratio = How much contribution is earned from each £1 of sales

Contribution
=
Sales revenue

Breakeven point = Sales revenue required to break even

Contribution required to break even (=Fixed costs)

=
Contribution ratio
 1. Break even analysis

Sales required to achieve expected profit

Required contribution (Fixed cost+Target profit)

Sales Units = =
Contribution per unit Contribution per unit

𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 (Fixed cost+Target profit)

Sales revenue = =
Contribution 𝑟𝑎𝑡𝑖𝑜 Contribution 𝑟𝑎𝑡𝑖𝑜
 2. Limiting factor analysis

2.1. Limiting factor ➔ profit maximizing

• Step 1: Identify limiting factor

• Step 2: Determine the contribution/ unit for each different product
(contribution per unit per factor)
• Step 3: Determine contribution/ limiting factor for each product
• Step 4: Rank
• Step 5: allocate & determine the optimal production plan
(Scarce resource: allocated to the highest ranking)
 2. Limiting factor analysis
2.2. Limiting factor: Extra supply of limiting factor
• Step 1: Identify contribution earned per each unit of the limiting
factor (contribution/ unit/ factor) ➔ rank
• Step 2: Determine the optimum plan using the extra resource
• Step 3: Accept the price if total contribution ≥ 0
➔ (Price – new variables): at least = 0
➔ Price – (current variables – current materials + new material) = 0
➔ New material = price – current variables + current material
= old contribution + current material
 2. Limiting factor analysis
2.3. Limiting factor: Restricted freedom of action

Might not be able to produce the profit-maximizing product mix:

• Contract ➔ cannot be cancelled
• Minimum quantity
• Maintain a certain market share
➔ Method:
• Fulfill: minimum production requirements
• Allocate the remaining resource according to the ranking
 2. Limiting factor analysis
4. Limiting factor: Make or buy decisions and scarce resources

Demand exceeds production capacity ➔ decision to :

• Whether to buy-in resources from external suppliers
• Which products to manufacture itself – which to subcontract
out
Rules:
• Minimise the total costs
• Priority for making in-house order:
Most expensive to buy ➔ cheaper to buy: saved more
 REVIEW

Chapter 11
Investment appraisal techniques

Phuong Thao NGUYEN

NEU - SAA
1. Investment appraisal techniques
Screening superior

Payback ARR NPV IRR

Accept: Accept: Accept: Accept:

PBP < TP ARR > TR NPV > 0 IRR > discount rate

Reject: Reject: Reject: Reject:

PBP > TP ARR < TR NPV < 0 IRR < discount rate
Cash flow Accounting profit Cash flow Cash flow
 Payback period
Even annual cashflows:

Initial payment
Payback period = (in year) (*12 ➔ in month)
Annual cash flow (evenly)

Unven annual cashflows:

Payback period ➔ calculate cumulative cash flow

 ARR

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐚𝐧𝐧𝐮𝐚𝐥 𝐩𝐫𝐨𝐟𝐢𝐭

ARR = x 100%
Accounting profit 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
after depreciation

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐚𝐧𝐧𝐮𝐚𝐥 𝐩𝐫𝐨𝐟𝐢𝐭

ARR = x 100%
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

Average investment = (initial investment + final or scrap value)/2

 ARR

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐚𝐧𝐧𝐮𝐚𝐥 𝐩𝐫𝐨𝐟𝐢𝐭

ARR = x 100%
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Accounting profit
after depreciation

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐚𝐧𝐧𝐮𝐚𝐥 𝐩𝐫𝐨𝐟𝐢𝐭

ARR = x 100%
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

Average investment = (initial investment + final or scrap value)/2

 NPV
Compounding TV = X(1 + r)n

𝑻𝑽
Discounting 𝑷𝑽 =
(𝟏 + 𝒓)𝒏

inflow inflow
PV = + +…
1+r1 (1+r1)(1+𝑟2)
𝟏
➔ Discount factor (𝟏 + 𝒓)𝒏
r: interest rate/ cost of capital
 NPV
NPV = present value of (expected future net cash
receipts – cost of the investment)
𝟏
Discounted at
(𝟏 + 𝒓)𝒏

NPV = present value of (cash inflow– cash outflow)

Annuities

Different
inflow
Conventions Non-Conventions
 NPV
First annuity: at Y1

Annuity factor

Limited Delay annuities

Annuities PV = Annuity x AF

1 year before the first cash flow

Annuities in advance
 NPV
First inflow: at Y1

Perpetuity Delay Perpetuity 𝒂

PV of perpetuity =
𝒓
1 year before the first cash flow
Perpetuity in
advance
 NPV
• A cash outlay (initial investment) ➔ occur now (Y0) ➔ DF =1

• Cash flows occur at the end of each year (unless told otherwise)

• Later cash flows occur at annual intervals: Y1, Y2….

➔ A cash flow occurring at the beginning of a time period: take to occur at

the end of the previous time period
 Non-conventional IRR
cash flows

Conventional cash-flow
 IRR Not even cash inflow

Start: r = 0
Graphic
➔ Sum of cash flow

Determine
IRR a: the first discount rate giving NPVa
b: the second discount rate giving NPVb

𝐍𝐏𝐕 𝐚
Interpolation IRR = a +
𝐍𝐏𝐕 𝐚 −𝐍𝐏𝐕 𝐛
x (b – a)

Try:
r = 2/3 or (3/4) ARR (average investment)
 IRR Even cash inflow - annuities

IRR – where NPV = 0 ➔ PV of inflow = outflow

➔ Annuities x factor = outflow

➔ Annuity factor (cumulative discount factor) = initial investment/ annuities

1. Find the annuity factor

2. Find the life of the project (n)

3. Use the table to find the closest value

➔ IRR
 IRR Even cash inflow – perpetuity

IRR – where NPV = 0 ➔ PV of inflow = outflow

➔ annual inflow /factor = outflow

➔IRR = annual inflow/ initial investment * 100%

PRACTICE
 IRR
1. A business undertakes high-risk investments and requires a minimum expected rate of
return of 17% on its investments. A proposed capital investment has the following expected
cash flows:
Year 0 1 2 3 4
£ (50,000) 18,000 25,000 20,000 10,000

Required:
a. Calculate the NPV of the project if the cost of capital is 15%
b. Calculate the NPV of the project if the cost of capital is 20%
c. Use the NPVs you have calculated to estimate the IRR
 IRR
2. Find the IRR of an investment of £50,000 if the inflows are:
- £5,000 in perpetuity
- £15,033 for 6 years (1st inflow in year 1)
- £12,124 for 5 years (1st inflow in year 2)
3. Effect of cash inflow’s changes on IRR/ NPV/ ARR/ PBP
- Cash inflow increase
- Cash inflow decrease
 IRR
4. Effect of cost of capital’s changes on IRR/ARR/NPV/PBP
5. Ranking – NPV, IRR, ARR, PBP
- Same outlay
- Same/ different inflow
- Lives
6. IRR decision: conventional and non-conventional cashflow
➔ Draw graph