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1.

An Introduction to Accounting and the Accounting Equation

Accounting may be defined as a series of processes and techniques used to identify, measure and communicate economic information which users find helpful in making decisions. Accounting is not an end in itself: it provides information to decision makers. It confines itself to economic information and is usually expressed in money values. However, accountants also deal with such things as tons of raw materials used, number of hours worked, capacity of machinery used, and units of output produced. Accounting information must be relevant for the purposes for which it is designed. Then, of course, the accountant must communicate the information in such a way that the users can understand it. Who are the users of a companys accounting information? Internal users: Directors, senior executives, managers, employees, and trade unions External users: Shareholders, analysts, creditors, tax authorities, the public Providing information about profitability and liquidity is seen by many to be the goal of the accounting system. The relationship between resources and the funds provided to acquire these resources is expressed in accounting like this: ASSETS = OWNERS EQUITY + LIABILITIES or ASSETS LIABILITIES = OWNERS EQUITY A profit and loss account shows how a companys profit was made. Profit is the excess in sales revenue over cost incurred in generating the revenue. Items of expenditure accounted for via the profit and loss account are called revenue expenditure. The balance sheet is a collection of balances after each transaction has been completed and recorded. Accounting entries involve a mixture of cash-driven items and judgment-driven items. Items for expenditure accounted for via the balance sheet are called capital expenditure. Fixed assets are of relatively long life and are generally used in the production of goods and services rather than be held for resale. Current assets are assets that are either currently in the form of cash or are close to being converted into cash within a short period of time (usually a year). Current liabilities are those obligations that a company must meet in cash within a short period of time (usually a year). A cash flow statement portrays only those economic events of a business that affect the cash flow. Why is the cash flow statement so important? It breaks the conventions separating the balance sheet and the P&L account and states all events that affect the cash flow. A sole trader can start trading at any time with assets at his disposal. He must, however, distinguish between the transactions that pertain to his business and those that are domestic in nature. In law he has unlimited liability. Because his creditors can pursue him beyond the limit of his business there is no requirement for him to make public his profit and loss account and balance sheet each year. In a partnership a number of individuals agree to set up business together, bringing to the partnership assets in varying proportions. As with the sole trader, a partnership need not make public its annual results because its creditors can pursue the partners beyond the limit of their equity in the partnership. A company structure avoids the risk of unlimited liability by limiting the liability of the owners (called shareholders) to the amount of equity (called share capital) paid into the company. In the event of legal action being taken against the company, shareholders cannot lose any more money than the sum paid for the shares. The accounting statements depicted in the previous section report the total picture of the firm for an accounting period: total sales, total costs, total profits, and total asset structure. This information is compiled after the accounting period is over and the books of account have been closed. This part of accounting is called financial accounting or financial reporting and derives from the legal obligation on directors and managers to report to the owners of the business (the shareholders) how they have used the resources at their disposal during the accounting period under review (usually annual). While financial reporting and an analysis of financial accounts are important for managers for a variety of decisions they have to make, the information contained therein is of little value in

helping them to plan and control the day-to-day activities of the business. The secret of good management lies in predicting the future, in plotting a course today which will steer the business through the turbulent seas of uncertainty lying ahead. To enable them to do this, management need detailed and relevant information. From the accounting process they need actual and projected costs and prices of individual products, actual and projected costs of individual departments and individual processes, projected sources and uses of cash, proposals for major investment in plant and equipment, and many other details. This information is called management accounting.

2.

The Profit and Loss Account

A glance at the profit and loss account will reveal that profit is the difference between the sales which the enterprise made during the period under review and all the costs which had been incurred to bring the goods sold to the market place ready for sale. These costs include: the direct costs of manufacture or preparation (the purchases of raw materials used, the wages of the workforce involved in the transformation process, and the costs of using up the equipment, namely depreciation); and the indirect costs (advertising and salaries of service support staff). Profit equals the measurement of accomplishment (sales) minus the measurement of effort (costs). Accomplishment is generally measured at the first point in the operating cycle at which all the following conditions are satisfied. 1. The principal revenue-producing service has been performed, i.e. the product has been made and delivered against a firm order. 2. All costs that are necessary to create the revenue have either been incurred or, if not yet incurred, are either negligible or can be predicted within an acceptable degree of accuracy. 3. The amount ultimately collectable in cash can be estimated within an acceptable range of error. The justification of the shipping and invoicing measure of accomplishment is that in most cases it is the first point in the cycle at which all three criteria are met and reflects what management have achieved by way of sales, not what they think they might achieve. Such a measure, although the most popular, need not be used if some other recognition basis meets the criteria better. Three other possible choices are: Time of Sales Orders, e.g. sales rep performance measurement Time of Production, e.g. ship building Time of Collection

Accounting is a series of techniques and procedures which have been developed by accountants over many years and which are called conventions. Two such conventions are adopted in measuring the sales figure: 1. The realisation convention: Only products that have been sold are measured as sales. Products which are completed or partially completed and have not realised value for the business are not included. 2. The accruals convention: Cash does not have to be received to create value; an obligation from a creditworthy customer is good enough to be called a sale. The accruals convention also covers the situation where a sole trader, or company or any other entity pays an invoice for a product or service which covers a period stretching beyond the date he/she draws up the financial statements. Efforts are all the costs involved in producing saleable products, and the costs involved in actually selling the products which are recognised in the measurement of sales accomplishment. The measurement of effort is governed by three conventions:

1.

The matching convention: Profit is arrived at by matching the effort (or costs) with the units shipped and invoiced to the customers (sales) during the period. 2. The allocation convention: The first task is to determine how much of each means of production, expressed in money terms, was consumed during the accounting period, that is, the companys total purchases of means of production (e.g. raw materials, power, wages of production workers) have to be allocated over the accounting period. The second task is to determine how much of each means of production, again expressed in money terms, should be matched with sales revenue and how much should be added to the closing work-inprogress (inventory of unfinished goods) and to the inventory of finished goods (on the assumption that goods remain unfinished at the end of the accounting period and that the business produces more finished units than it sells). It will be noted that the second task is similar to the procedures adopted under the matching convention. 3. The cost convention: The means of production is measured and expressed in money terms. The general rule is found in the cost convention: accountants use the historical (or acquisition) cost of different means of production, that is, the price paid for them by the business when they were acquired. The figure for raw materials used, often the largest of all the costs of production, is determined by deducting the physical quantity of raw materials at the end of the year from the sum of opening inventory of raw materials and purchases during the year. Four valuation possibilities suggest themselves: 1. 2. 3. 4. Using the last price paid for all the closing inventory; Counting back using actual prices; Using earliest prices; Using the average cost of units.

The difference in stock valuation is significant. The annual (or monthly, or weekly) payroll is the usual source for the measurement of labour effort expended. The information comes from the pay records and is in money terms. Depreciation charges are based on rule-of-thumb procedures devised by engineers and accountants which try to reflect the periodic use of plant and machinery. The periodic charge for depreciation is calculated having regard to three factors:

1.
if any;

the actual historic (sometimes called acquisition) cost, including installation charges

2.

the estimated net residual amount which the business will receive for the asset on disposal; 3. the estimated useful life of the asset to the present owner. Note that two of the three factors are nothing more than estimates. The selection of method influences the amount of cost allocated to each accounting period; the amount of depreciation allocated in turn influences reported profit. Method 1 Straight-line Depreciation: The straight-line depreciation method is widely used because it is simple and reasonable in respect of many kinds of fixed assets. An equal portion of the original acquisition cost less estimated residual value is allocated to each accounting period during the assets service life. Method 2 Reducing Balance Depreciation: This method is based on the notion that there should be relatively large amounts of depreciation expense reported in earlier years of the service life and correspondingly reduced amounts of depreciation expense in the later years. The basis for this method is that a fixed asset is more efficient in generating revenue in the earlier years than in the later years of life, therefore it makes sense to allocate more cost against earlier years revenue than later years. Also, repair expenditure tends to be low in the early years and higher in the later years, therefore it makes sense to counterbalance the low early maintenance with high early depreciation. Method 3 Consumption Method: The consumption method is based on the

number of running hours of the machine: the assumption is the greater the machine hours run, the greater is the wear and tear on the machine. The next step is to value the closing inventories of finished goods and work-in-progress, then these costs must be deducted from the total costs measured before and the balance is set off as a charge in the profit and loss account. The selection of an inventory valuation system is very important because it will have a major impact on the measurement of effort, and consequently on reported profit, for any accounting period. In other words: the higher the ending inventory valuation, the higher the reported profit; alternatively the lower the ending inventory valuation, the lower the reported profit.

The kind of inventory normally held depends on the characteristics of the business. In a manufacturing operation we usually find the following categories.

1.

Finished goods inventory: goods manufactured by the business, completed and ready for sale. 2. Work-in-progress inventory: goods in the progress of being manufactured but not yet completed as finished goods. 3. Raw materials and supplies inventory: items acquired by purchase to be used in the manufacturing process. Inventory, once physically counted, is valued according to a mixture of cost and conservatism conventions in accounting. A choice among the inventory costing methods is necessary only when there are different unit costs in the opening inventory and/or the purchases made during the accounting period. Generally accepted accounting principles require that the inventory costing method must be rational and systematic. First In, First Out (FIFO): The first in, first out method assumes that the oldest unit costs (the first units purchased) are the first ones sold. This means that the units left in inventory at the end of the accounting period are deemed to be the latest purchased and therefore valued at the latest prices. FIFO is favoured by many businesses because it is consistent with the physical flow of the goods. Also, the balance sheet inventory is carried at current realistic values, provided the stock is turned over quickly. Its greatest drawback, however, is that the reported income is relatively high during periods of rising prices because of the oldest and lowest costs which have been set off against sales revenue. High reported income leads to high taxes, high dividends and potentially high wage demands. And of course inventory must be replaced, demanding more cash outlay. When prices are rising, companies find it increasingly difficult to replace the physical volume of inventory used and sold. Last In, First Out (LIFO): The last in, first out method assumes that the most recently acquired goods are sold first. Irrespective of the physical flow of goods, LIFO assumes that the most recent purchases (and therefore the most recent prices) are transferred first into production, leaving in the ending inventory the oldest (and lowest priced) units. Thus the LIFO method attains results that are the opposite to FIFO: lower profit is reported in times of rising prices and replacement of inventories is therefore made easier. However, many managers do not want to report the lower profit figure. Average Method: The average method involves computing the weighted average unit cost of the goods available for sale. The average unit cost is then applied to (a) the number of units sold in order to calculate the cost of goods sold, and (b) the number of units in the ending inventory to measure the inventory value. Very often tax minimisation is a primary goal of management: in times of rising prices LIFO will result in lower-valued inventories, therefore higher costs being passed into cost of sales and hence lower profits. Most managers believe that the best inventory valuation method is the one that best matches the sales pricing policy of the company. Businesses, it is thought, set selling prices within a LIFO assumption since the inventory used up through sales must be replaced on the shelf at the latest cost rather than the earlier cost.

Two of the costs which have been examined in detail in this module, raw materials and labour, are known as product costs. Such costs can be traced directly to the products being manufactured, or to the production process. In addition to the ones just mentioned we can add various factory overheads such as indirect labour (assume that the labour costs considered so far were wages of operatives directly involved in manufacturing) representing wages and salaries earned by supervisors, warehouse staff and maintenance engineers, all of whom do not work directly on the products but whose services are connected to the production process. Other factory overheads would include heat, light and power, supplies and maintenance, depreciation and asset insurances. There is another category of costs which companies incur and which are set off against sales revenue in the profit and loss account without any question of including them in the valuation of closing inventory. Such costs are called period costs. Examples of period costs are selling, distribution and marketing costs, general administrative costs and financial charges. These costs are incurred so that a companys products can be sold, and the money can be collected from the customer, but they typically do not add value to the products unsold at the end of the accounting period. They are therefore written off each year. The way in which a company classifies its costs into period costs and product costs can have a significant effect on the reported profit figure. The more costs a company deems to be product costs, the higher the inventory valuation will be at the end of the accounting period. And the higher the inventory, it will be recalled, the higher the reported profit figure. If a measure of the efficiency of the transformation process is wanted the gross profit figure should be selected, that is, sales less cost of sales. Net profit, on the other hand, which reflects the further expenditure identified normally as period costs, enables the reader to judge overall managerial efficiency against both previous accounting periods and other companies engaged in similar fields. The most commonly used measure of managerial efficiency is net profit before interest charges and taxes: managements efficiency of manufacturing, selling and distributing the companys products should not be affected by the financing arrangements made to bring about the trading results. If the reader wants to assess the companys financial structure the important figures are the interest payment (interest, that is, on money borrowed from non-shareholders) and the net profit after interest but before taxes. The profit and loss account measures the difference between accomplishment (sales) and effort (cost of sales and other overheads). Sales are measured by reference to goods and services shipped and invoiced to the customer and are not dependent on the cash received. Cost of sales are measured by reference to the valuation of inventory of raw materials, workin-progress and finished goods at the end of the accounting period. This inventory can be valued in one of a number of ways, each one producing a different cost of sales figure and therefore a different profit figure. Depreciation is another cost which is subject to a variety of methods of calculation. Care must be taken to segregate product costs from period costs. The latter category must be written off in the profit and loss account while the former can be inventoried and carried forward in the valuation of inventory in the balance sheet. Profit can be calculated at a number of levels, before and after overheads, and before and after interest and taxes. Managers must select the figure which best suits their purpose.

3.

The Balance Sheet

Assets can be described as (a) the untransformed means of production like land, buildings, plant and machinery and raw materials; and (b) the transformed means of production like work-in-progress and finished goods which have not yet been released into the profit and loss account. Fixed assets are those assets that a company keeps for a substantial period of time (like land and buildings or plant and equipment or motor vehicles), not for resale, but to use in the course of business. It is the intention of management as to the use of the asset, not its physical characteristics, that determines whether or not it is classified as a fixed asset. Categories of fixed assets are: Land Buildings Plant and equipment

Fixed Assets not owned by the company: the asset appears under the heading fixed assets and the future lease payments under creditors. The distinction should be made between the expense of maintaining and operating the fixed assets and the depreciation which is charged. Maintenance expenditure is an expense which is charged against profits in the period of outlay. Depreciation, on the other hand, is the allocation of a previously incurred cost. For the sake of completeness, it should be noted that assets acquired under an operating lease (one in which ownership remains with the lessor) are not capitalised.. Both the capital and interest elements of the operating lease payments are charged in the profit and loss account. In the case of finance leases only the interest element is charged to the profit and loss account while the capital portion is deducted from the lease obligation amount in the balance sheet. Current assets are assets which are expected to be sold or consumed during the normal operating cycle of the company (usually one year). Categories of current assets are: Inventories: the valuation is based n the lower of the cost or current market value rule; cost is defined as direct manufacturing cost plus a share of manufacturing overhead (period cost such as administration overhead are not included in inventory); inventory valuation methods can influence the value of the inventory and any changes in valuation methods has to be properly disclosed Debtors: payment by debtors is expected shortly after the start of the next accounting period. Provisions for bad debts are entered at the beginning in the P&L account and subsequently changes in those provisions and actual bad debts are entered in the P&L account. Cash Current liabilities are liabilities which is plans to meet in the short term by the payment of cash. Examples are creditors, bank overdraft, taxes payable, dividends payable, accruals, and deferred revenue. The balance sheet is often described as a snapshot of a companys resources on a given date. Imagine the view from a helicopter sent up to take an aerial photograph of a company. Plant and equipment, land and buildings, piles of inventory (raw materials, work-in-progress and finished goods) would be picked out by the camera, maybe even the cash drawers stuffed with money. The profit and loss, by contrast, could be regarded as a video of the companys activities during the year. A video is a moving picture, not a static snapshot, and would reflect the constantly fluid operations of accomplishment and effort, the purchasing, manufacturing and selling activities which reflect the companys raison dtre.

4.

The Cash Flow Statement

Cash flow statements are needed to unstitch the accounting principles which are applied to compile balance sheets and profit and loss accounts and to reveal whether the entity has sufficient cash funds to finance its future operations and its future ambitions for dividend payments to the owners and investments in assets and acquisition of other businesses. Where does cash come from? Profit from Operations Capital Introduction Increase in Creditors Sale of Fixed Assets Loans Decrease in Inventories Decrease in Debtors

Where does cash go to? Loss from Operations

Capital Repayments Decrease in Creditors Purchase of Fixed Assets Repayment of Loans Increase of Inventories Increase in Debtors

Eight major categories of cash flow = Our Really Tall Cat Ate Everyones Meaty Food: 1. 2. 3. 4. 5. 6. 7. 8. Operating activities Returns on investments and servicing of finance Taxation Capital investment Acquisitions and disposals Equity dividends paid to shareholders Management of liquid resources Financing

What is needed to draw up the cash flow statement? The profit and loss account for the period The balance sheet at the start of the period The balance sheet at the end of the period Supplementary notes to the financial statements

Of the three financial statements regularly prepared by companies and other organizations the cash flow statement is arguably the most critical. This is because entities need cash to survive; cash is the lifeblood that keeps them alive. Cash flow statements allow users of financial reports to assess a companys liquidity and financial adaptability. Remember: Market share is VANITY; Profit is SANITY; Cash flow is REALITY.

5.

The Framework for Financial Reporting

The material which follows refers to the reporting environment influenced by the work of the International Accounting Standards Board (IASB) through its international financial reporting standards (IFRSs). These are sometimes referred to, inaccurately, as international accounting standards (IASs); in fact IASs were issued by the International Accounting Standards Committee which preceded the IASB whose subsequent standards are known as IFRSs. The term IAS still applies to earlier standards which the IASB has been prepared to endorse since its inception in 2000. The overall requirement of the law is that the companys profit and loss account and balance sheet shall give a true and fair view of, respectively, the profit or loss for the financial year, and the state of affairs as at the end thereof. Generally it is interpreted to mean that the financial statements have been drawn up according to accepted accounting principles using accurate figures as far as possible, and reasonable estimates otherwise, and that the whole picture is free from deliberate bias, manipulation or concealment of material facts. A companys auditor must certify every year that a true and fair view has been given of the companys profits and state of affairs. The accounting profession, in 1969, took it upon itself to issue standards for accounting procedures which its members are obliged to follow. The standards, properly termed Statements of Standard Accounting Practice or SSAPs, were issued on behalf of the various professional accounting bodies by the Accounting Standards Committee up to 1990 and from this date Financial Reporting Standards, or FRSs, have been issued by the Accounting Standards Board, a body independent of the professional accounting bodies.

The distinction between the Companies Act and accounting standards should be stressed: the Companies Act lays down that companies must disclose certain information, predominantly of a financial nature, about its affairs during the accounting year under review. Accounting standards, on the other hand, underpin the financial disclosures in that they set controls on how the numbers in the financial statements are to be compiled. In order to promote harmonisation of regulations and procedures throughout the world, the International Accounting Standards Committee (IASC) was set up in 1973. In an effort to embrace many member countries own standards setting efforts, the requirements of the early international standards permitted a wide range of options. Finance directors did not find it difficult to comply with IASC standards if, first, they had met the requirements of their nationally set standards. But the pace quickened in the late 1990s when some companies abused the relatively liberal regime of both national and international standards and the IASC was reconstituted the International Accounting Standards Board (IASB) in 2000. Groups of companies are recognised in law and their combined financial results must be reported in consolidated, or group, financial statements. The responsibility for publishing group accounts rests with the holding company, that is the company which owns the shareholdings (over 50 per cent) in the subsidiary companies in the group. The holding company must publish not only the group profit and loss account and group balance sheet, but also its own balance sheet. The subsidiary companies must continue to publish their own financial statements in the usual way. Experienced readers of annual accounts always start their examination with the enterprises Accounting Principles and Policies. These brief statements are required by IAS 1 Presentation of Financial Statements. Accounting policies are the specific accounting bases selected and consistently followed by a business enterprise as being, in the opinion of the management, appropriate to its circumstances and best suited to present fairly its results and financial position. Three lessons can be learned from the foregoing paragraphs in this module. 1. Disclosure requirements are numerous and complex and require detailed interpretation by company management, accountants and lawyers, and by the auditors (to whose role we shall turn next). MBA students and managers do not need to master the detail. 2. A corporate tradition has been built up of disclosing the absolute minimum information required. Very seldom does a company publish information that is not mandatory. 3. Despite a rigorous application of disclosure requirements, large gaps in information can still be detected by interested readers. In attempting to understand the annual report and accounts of any company the reader should appreciate the seven fundamental accounting principles that underpin their preparation. These are set out in IAS 1. Fair Presentation: A fair presentation requires management to select and apply accounting policies (e.g. the depreciation method or the inventory valuation method) which are relevant to the users and are reliable in that they (a) represent faithfully the results and financial position of the enterprise; (b) reflect the economic substance of events and transactions and not merely the legal form; (c) are neutral, that is free from bias; (d) are prudent; and (e) are complete in all material respects. The Going Concern Principle: If management is aware of material uncertainties related to events or conditions that may cast significant doubt upon the entitys ability to continue as a going concern, these uncertainties should be disclosed. The standard requires management to review all available evidence relating to at least the period of twelve months from the balance sheet. Significant doubts about such matters as a collapse in orders, repayment of debt falling due, payment of interest on current debt levels or continuing support of banks and other providers of debt could trigger the need to draw up the financial statements prepared on a basis other than going concern. In practice this would lead to a material write-down of the carrying value of assets in the balance sheet which, in turn would hit the profit and loss account. The Accrual Basis of Accounting: Financial statements drawn up on the accrual basis inform users not only of past transactions involving payment and receipt of cash but they also reflect the obligations to pay cash or the prospect of receiving cash in the future.

The Consistency Principle: In order to provide a reflection of the affairs on an entity it is essential that readers get presented with information which has been prepared on a consistent basis. This allows the reader to compare this years performance with the previous years. IAS 1 requires entities to stick to its presentation and classifications from one year to another unless there are compelling reasons to change them. A significant acquisition or disposal, or a review of the presentation style, might suggest that a change is required. This change is only permissible if the changed presentation provides information that is reliable and is more relevant to the users and that the revised structure is likely to continue, so that users will be able to compare years performances in the future. Materiality, Aggregation and Offset: Each material class of similar items must be presented separately; and items of a dissimilar nature of function should be shown separately unless they are immaterial. So if a line item is not individually material it should be aggregated with other items either on the face of those statements or in the notes. Profit or Loss for a Period: Every gain or loss, whether it arose from the normal operations of the business or from the purchase or sale of assets, should be captured in the profit and loss account. (Cant find a seventh accounting principle in this list in the textbook) Legislation in most countries requires that all limited companies have their accounts audited by independent persons who hold an accounting qualification recognised by the government. The auditors are required to make a report to the shareholders on the accounts examined by them. This report forms part of the published financial statements. The report shall state whether, in the auditors opinion, a true and fair view is given of the profit (or loss) for the year and of the financial position at year-end. To enable them to make a report, the auditors must ensure that the books, records and internal controls have been satisfactorily maintained during the accounting period. The principal aspects of their work include: an examination of the system of bookkeeping, accounting and internal control to ascertain whether it is appropriate for the business and properly records all transactions. This is followed by such tests and enquiries as are considered necessary to ascertain whether the system is being properly carried out. Both these steps are necessary to form a basis for the preparation of the accounts; comparison of the balance sheet and profit and loss account and other statements with the underlying records in order to see that they are in accordance therewith; verification of the title, existence and value of the assets appearing in the balance sheet; verification of the amount of the liabilities appearing in the balance sheet; verification that the results shown by the profit and loss account are fairly stated; and confirmation that the statutory requirements have been complied with and that the relevant accounting standards have been applied correctly. Internal control is a term used to describe all the various measures taken by the owners and managers of a company to direct and control their employees. Managers are constrained by three sets of rules when constructing corporate financial statements: 1. company legislation passed by the government of the country in which the company is registered; 2. the accounting standards set by the accounting profession or its regulators; and 3. the listing requirements of the stock exchange. Few companies disclose any information not required. Groups of companies consolidate their results at the end of the financial year into a group profit and loss account and a group balance sheet; in addition the parent company must publish its own balance sheet. An auditor is required to report to the shareholders of a company on whether or not the accounts reflect a true and fair view of the companys affairs. To do this he or she undertakes a series of checks and examinations of the companys books and internal controls.

6.

Interpretation of Financial Statements

Percentages, or ratios, permit easy comparison between different corporate entities: divisions within the company, companies within the same group, or companies within the same industrial sector. The frequently used benchmarks for the purposes of comparison are the data produced by the various clearing houses for industrial statistics. In ratio analysis it is important to study the trend of the ratios calculated rather than to attempt to arrive at sound conclusions on one years numbers. Ratio Analysis: Liquidity Ratios: Liquidity ratios are designed to measure a companys ability to meet its maturing short-term obligations. Profitability Ratios: Profitability ratios are designed to measure managements overall effectiveness. Capital Structure Ratios: Capital structure ratios are divided into two groups which are: (a) those that examine the asset structure of the company; and (b) those that analyse the financing arrangements of the companys total assets, in particular the extent to which the company relies on debt. This group of ratios is generally known as the gearing ratios. Efficiency Ratios: Efficiency ratios give an indication of how effectively a company has been managing its assets. 1. Group 1: Liquidity Ratios

A company is in a good position to meet its current obligations if current assets exceed current liabilities by a comfortable margin. 2. Current ratio = Current assets/Current liabilities Quick ratio (or acid test) = (Current assets Inventory)/Current liabilities Group 2: Profitability Ratios

Gross profit margin = Gross profit/Revenues Profit margin = Profit from ordinary activities before taxation/Revenues Return on total assets = Profit from ordinary activities before taxation/Total assets Return on inventory = Profit from ordinary activities before taxation/Inventory Return on capital employed = Profit from ordinary activities before taxation/Capital employed (Capital employed = Working Capital (Current Assets Current Liabilities) + Fixed Assets) Return on owners equity = Profit from ordinary activities attributable to shareholders/Owners equity 3. Group 3: Capital Structure Ratios

Fixed (Non-current) to current asset ratio = Fixed (Non-current) assets/Current assets Debt ratio = Total debt/Total assets (gearing ratio) Times interest earned = Profit before financial result (=Profit from operations)/Interest charges (gearing ratio) 4. Group 4: Efficiency Ratios Inventory turnover = Cost of sales/Inventory Average collection period = Trade receivables/Revenues per day Non-current asset turnover = Revenues/Non-current assets

One ratio is deemed by most companies to be ultimately significant, namely Return on Total Assets (ROTA).

Furthermore: Basic Stock Market Ratios payout Earnings per share (EPS) = Net profit/Number of ordinary shares in issue Price/earnings ratio (EP) = Market price/EPS Dividend yield = Dividend per share/Market value per share Dividend cover = Profit from ordinary activities attributable to common stock/Dividend

Financial statements report absolute figures. But these figures by themselves do not reveal much about the company; they need to be related one to another so that internal strengths and weaknesses can be revealed. Ratio analysis only produces insights when it is carried out for a number of years and when the ratios are compared with industrial averages. The most prominent ratios can be grouped into four categories. 1. liquidity ratios which are designed to measure a companys ability to meet its maturing short-term obligations; 2. profitability ratios which strike at the heart of a companys activities, namely whether it controls expenses and earns a reasonable return on funds invested; 3. capital structure ratios which examine the percentage of a companys total assets which are contributed by shareholders and the effect and risk of such a percentage on the earnings; and 4. efficiency ratios which measure the companys asset management. Stock market ratios are also critical for the management of a quoted company but because these are based on the daily share price these ratios tend not to be controllable in the short term. No set of ratios is sacrosanct; the secret of good ratio analysis is to understand the underlying significance of a small number of ratios and then apply them consistently through time and across companies.

7. Emerging and Controversial Issues in International Financial Reporting


The pressure on profits or more specifically earnings per share for that is the ultimate indicator of corporate growth is a phenomenon referred to as shorttermism. Depending on the terms of business combination, i.e. how a company becomes a subsidiary of a holding company, accounting practice permits two types of group accounts which produce starkly different numbers. These two practices are known as acquisition accounting and merger accounting (sometimes referred to as business combinations). Acquisition accounting (sometimes called purchase method accounting) is used to reflect normal takeovers where the predator company (called the holding company in this module) acquires more than 50 per cent of the equity share capital of the target (called the subsidiary) for cash, or shares in the holding company, or a combination of cash and shares. Merger accounting (sometimes called pooling of interests) is based on the concept of harmony and agreement rather than the hawkish behaviour of predator and prey which underpins acquisition accounting. A merger (as opposed to a takeover) presumes agreement between the two parties to pool their respective interests rather than for the one to hand over its assets to another. The accounting statements in merger accounting attempt to portray this harmonious coming together by restating both companies accounts as if the two companies had always been one. Internally Generated Intangible Assets: Research and Development: Research expenditure must be written off to the profit and loss account because the company cannot demonstrate that an intangible asset exists that will generate probable economic benefits. Development expenditure should be recognised as an internally generated intangible asset only if the company can demonstrate identifiability, control, and existence of future economic benefits.

Website Costs: Planning (expenses), application and infrastructure development (intangible asset), graphical design development (intangible asset), content development (expenses), operating stage (expenses). Share-Based Payments: The day of grant is the date on which the employee is informed of the award of options. To provide the necessary incentive and motivation the board, or its remuneration committee if the company has such a body, will set the price of the option above the price of the share on the day of grant. The vesting day is the day on which the vesting conditions (e.g. length of time to be served or profitability levels to be reached before options become payable) have been satisfied. If the share price on vesting day is above the price set by the board on the day of grant the options are seen to be in the money; on the other hand if the vesting day share price is below the day of grant value the options are under water. The period between the day of grant and vesting day is called the vesting period. If the options are claimed on this day, the day is also known as the exercise day. If the exercise day lies beyond the vesting date, as so often is the case, the time between vesting day and exercise day is called the exercise period. The life of the option is the period between the day of the grant and the last day on which the grant can be exercised, beyond which the grant expires. Share-based options are valued at the fair value of the equity instrument at the date when it was originally granted; should it not be possible to determine fair value reliably, management may use intrinsic value, that is the price of the underlying share less the exercise price, if any, for the award. Pensions are employee benefits which are payable after the completion of employment. They come in two forms: Defined contributions where a company pays an agreed contribution each year into a pension fund on behalf of an employee. This fund is typically managed by a life assurance company or other professional investor; at the end of employment the fund will pay out a pension the amount of which is heavily dependent on the success of the funds investments over the years the employee was working. Should the employee find the pension less than was indicated by the pension provider during employment or simply insufficient to meet his/her needs, the company has no further responsibility. From the employers stance we think the term defined inputs would capture the nature of this type of pension funding. Defined benefits (or in our parlance defined outputs) which guarantees the pensioner a set amount each year based usually on his/her final salary or the average of the last three (or more) years salary. Note the term guarantee; should the fund to which the employer and employee has contributed during the pensioners working life not have sufficient assets in it to fund the defined benefits, the company has a responsibility to top it up. What is a Financial Instrument? IAS 39 defines a financial instrument as any contract that gives rise to a financial asset of one enterprise and a financial liability or equity instrument of another enterprise. So the financial instrument is the contract, not the financial asset or financial liability. The four categories for financial assets and/or financial liabilities are: 1. Held for trading: this is an asset which was acquired or incurred principally for the purpose of generating profit from short-term fluctuations in price or dealers margin. 2. Held-to-maturity investments: these are financial assets with fixed or determinable payments and fixed maturity that a company plans to hold to maturity. 3. Loans and receivables originated by the enterprise: these are financial assets that are created by the company by providing money, goods or services directly to a debtor other than those the company plans to factor (which should be categorised as held for trading. 4. Available for sale: these are financial assets that are not captured by the other three categories.

These categories are important because IAS 39 lays down two sets of measurement rules. Financial assets held for trading and those available for sale are to be measured at fair value (remember the definition of fair value: the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arms length transaction) and the other two categories, assets held-to-maturity and loans and receivables are to be measured at amortised cost using the effective market rate. A provision is recognised as a liability (assuming that a reliable estimate can be made) because it is a present obligation and it is probable that an outflow of cash or other resource will be required to settle the obligation. A contingent liability, on the other hand, is not recognised as a liability in the balance sheet because it is either only (a) a possible obligation as it has yet to be confirmed whether the company has an obligation that could lead to an outflow of cash; or (b) a present obligation whose probability of cash outflow is low or for which a sufficiently reliable estimate cannot be made. A contingent asset is defined more simply: it is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the company.

8.

An Introduction to Cost and Management Accounting

The forward-looking branch of the accounting discipline is called management accounting. Readers should note from the outset that the characteristics of the same global definition apply to management accounting as to financial accounting and reporting. The difference between financial accounting and management accounting can be described as financial accounting reports on management and management accounting reports for management.

Financial Accounting Structure No formal structure, can be designed to suit Highly structured many purposes, each with its own set of around the guidelines. accounting equation. Rules No externally imposed rules. Rigid handling of Hemmed in by asset valuations, overhead allocation and general accounting revenue recognition is relaxed. principles to enable comparison across companies. Compulsory No, but few succeed without a system, however Yes, companies informal. No value in maintaining one if it is not are obliged by law useful. to produce external accounts. Money Not exclusively. Yes, financial terms statements are drawn up exclusively in money terms. Time Spans Information tends to be future oriented. Records and Management might compromise precision for reports past speed. events as accurately as the underlying accounting principles permit.

Management Accounting

Whole parts Audit

or By its nature fragmented. Focuses on product Reports the events lines, departments, processes, etc. Information of the company as can be reworked in many different ways a whole. Strictly speaking, no, although the external Yes, accounts auditors may with to test the internal controls by have to be audited examining aspects of the management by a registered accounting system. An internal audit function auditor. might use the management accounting system as its basis.

Planning and coordination and directing and control are the two groups of tasks for managers. To assist managers in these they need information that allows them to take decisions. Cost accounting is a major and essential part of management accounting. The classification, collection and analysis of costs, principal features of cost accounting, are fundamental to management planning and control. Costing systems are designed to facilitate the allocation or apportionment of expenditure to cost centres (the smallest unit of activity or area of responsibility for which costs are accumulated) or to products. Costs are allocated to products if the relationship is obvious; these are called direct costs. Other costs such as the heating and lighting in the workshop, depreciation of the machinery, salaries of the administrative staff are called indirect costs and have to be apportioned by some given formula to the products. Materials first must be quantified and then must be priced. The cost accounting system usually records the amount of raw material that is drawn from the stores for use in the assembly process. The amount is recorded on a stores requisition slip which shows both the quality and the quantity of the material drawn. This slip is used not only to cost the individual units but to update the records for raw material inventory which will eventually need replenishment. Direct labour is that part of the total labour cost which can be traced to, or otherwise identified with, the units of output produced. The higher the volume, the higher the labour costs. Typically, direct labour comprises those employees who are closest to the manufacturing or assembling process. Again, the direct labour must be measured in terms of time and price. Manufacturing overheads is a broad category of cost which includes all costs associated with manufacturing other than direct material and direct labour. Examples are indirect labour of those employees associated, but not directly, with production, supplies, factory heating and lighting, power, machine maintenance and depreciation. Non-manufacturing overheads are administrative costs, selling and distribution costs and financial expenses. The system described above is known as job costing, appropriate where the units of output are sufficiently identifiable to pinpoint the direct material and labour applied to each unit. There are many areas where the items produced are so homogeneous that physical identification is impossible; examples are refining, chemical processing and manufacturing activities where products are continuously produced in an unvarying mix. In these cases, job costing is impossible to operate and another system called process costing is adopted. Process costing systems collect costs for all the products worked on during an accounting period and, by dividing these total costs by the total number of units worked on during the same period, determine the cost for each unit. Management decisions can be split into two broad categories: routine and special. Routine decisions are concerned with the day-to-day operations of the enterprise: ensuring that the agreed volume of output is produced in the agreed manner, ironing out problems that arise with supplies of raw materials or with the production workers, in general encouraging staff to achieve the companys objectives as efficiently as possible. For these tasks the manager needs much cost information, mostly of a routine nature, which the cost accounting system is designed to produce. Special decisions need special cost information which does not fall out easily from the cost accounting system. The management accountant must package the relevant cost information in a manner most appropriate for managers to make their decision. The overriding criteria for management accounting information are relevance and timeliness.

9.

Cost Characteristics and Behaviour

With a knowledge of cost, managers can control actual performance against planned performance and take corrective action if necessary; plan next years costs carefully, making due allowance for inefficiencies and unforeseen events which distorted last years performance; determine a desirable selling price (whether in terms of ticket price in the market or subsidy sought from local or central government), even though that price may not be achievable; track the consumption of the organisations resources to ensure that all employees are carrying out their duties efficiently and honestly; choose among alternative courses of action (while recognising, of course, that decisions are made on many more criteria than cost). Fixed costs do not change with a change in production levels; variable costs change proportionately with the production levels. Costs that are seen to be incurred only because of the item manufactured are termed direct costs; all other costs are indirect costs. Indirect costs are seen by the accountants as being costs incurred in support of the fundamental activities of manufacturing, buying, and selling; they are not attributable to a single product or range of products. Without qualification we believe traceable costs are the same as direct costs and common costs are the same as indirect costs. Note that, if a business produces only one product line, it will not have any common costs because every cost can be directly traced to the cost items produced. Product costs are costs that can be attached to the cost item without undue difficulty; period costs are those costs which, although incurred ultimately in the support of the product, are best controlled in time periods. Note that product costs contain a blend of variable and fixed costs, direct and indirect costs (and therefore traceable and common costs). So do period costs. The significance of this cost category is in valuing inventory for financial reporting purposes. It is not a useful tool for managerial planning and control. The cost category of controllable and non-controllable costs most certainly has managerial importance. The word controllable refers to the person, the manager or foreman or supervisor, who can be held accountable for the costs being measured. Before a business can assess its performance, in totality or in individual segments, it must know the benchmarks against which its achievements can be measured. In terms of detailed costs and revenues for individual products and services, a business usually sets up standard costs, the budgeted costs for one cost item, which are based not only on engineering studies but on recent experience. Against this norm, the actual costs are measured period by period. Management would want to receive explanations for significant variances between the two sets of figures. Note that a standard cost would comprise both variable costs of the cost unit and a share of fixed costs. Costs that can not be avoided in the production of a cost item (such as the raw material and the labour it takes to produce the item), that is costs that are engineered into the product are called engineering costs. All other costs, e.g. machine maintenance, R&D, etc., must not necessarily be incurred in every accounting period; these costs are called discretionary costs. Discretionary costs can be reduced rather quickly if the business faces a decline. Of all the distinctions we have made so far among costs, easily the most useful in terms of quick managerial insight into a business is that between variable and fixed costs. This insight can be gained by an understanding of the break-even chart which develops the relationships between cost and output. Break-even is the point in the operations where, if the business sold all the units made, the total costs (variable and fixed costs) would be exactly met by the revenue from sales. At the break-even point the business makes neither a profit nor a loss. The graphical representation of cost is useful because the various relationships between costs and volume can be clearly understood but we can juggle with the various factors comprising break-even analysis in a number of ways.

Equation method (calculates revenues or break-even sales): Break-even sales = Fixed costs + Variable costs (Sales = Fixed costs + Variable costs + Profit) Contribution margin method (calculates break-even number of units): Contribution margin = Sales revenue per unit Variable costs per unit; then BEP = Fixed costs/Contribution margin The secret of good management is to identify the limiting factors and calculate the contribution margin per unit of limiting factor. The higher the contribution margin per limiting factor, the more the good in question contributes to the bottom line. Contribution Margin Ratio Method (or Profit/Volume Ratio) = (Sales price Variable costs)/Sales price; then BEP = Fixed costs/P/V ratio The profit/volume ratio is used in the break-even decision making and measures the impact of volume on profit. Assumptions underlying the cost-volume-price analysis: 1. All costs can be identified as either fixed or variable. 2. Variable costs rise linearly, fixed costs are the same for all volumes produced. 3. Sales price per unit remains unchanged. 4. The sales mix (mix of products) will be maintained precisely as budgeted, as total volume moves up or down. 5. All production is sold. These assumptions restrain the usefulness of the break-even analysis in real world situations. However, the analysis of cost behaviour is useful in many situations of decisionmaking.

10.

Allocating Costs to Jobs and Processes

Where do costs come from? Materials Labour Manufacturing overheads Non-manufacturing overheads

Because overheads are not directly attributable to cost units in the same manner as direct materials and direct labour where the actual usage of resources can be tracked precisely, accountants use a predetermined overhead rate with which to spread overheads across the units of production. This rate is based on the following calculation: Predetermined overhead allocation rate = Budgeted overhead for accounting period/Budgeted production units Difficulties arise, however, in a business which produces more than one product. If these products have different production characteristics (that is, they consume differing proportions of the factors of production including overhead costs) the simple fraction above does not work because the budgeted production units cannot be added together. Cost accountants search for causal factors or activity bases, the one particular factor which prompts the incurrence of most of the headings of cost which comprise overhead. Typical activity bases are direct labour hours, or direct labour cost or machine-hours. A close examination of overheads in each business will reveal that one of these activity bases can be seen to cause the majority of the overheads (but by no means all). It is virtually impossible to estimate accurately both the numerator (budgeted overheads) and the denominator (budgeted level of production expressed in terms of an activity base). The difference between the actual figure of overhead incurred and that allocated to the product is accounted directly to the profit and loss account. To assume the same linkage to the selected activity base for all overhead costs can lead to

misleading allocations and therefore product costs. Management must design a costallocation system which reflects each products actual usage of overheads rather than adhere to the blunt instrument of a plantwide rate. Typical activity bases for service department costs include the following: personnel/welfare services: number of persons employed; computing: hours run; number of reports issued; machinery: machine-hours; buildings and estate: space occupied; power: machine-hours; metered usage; executive salaries: sales; production scheduling: number of different products.

Cost accountants use many methods which revolve around two principal techniques, the direct method and the step method. In the direct method, the overhead costs for each of the service departments are emptied out into the production departments and added to the overheads already there to calculate two predetermined overhead rates. The second technique, the step method, recognises the interdependency among departments. A sequence to close down service departments costs must be established. Two of the most common are: (a) select service departments in descending order of magnitude of overhead spend, and (b) select first the department that renders the highest percentage of its total services to other service departments and end with the one that renders the lowest percentage of service to other service departments. In some industries, work is concentrated on the production of one product but other products are produced which may or may not have significant market potential. The true characteristic of a joint product is that it must appear during the processes involved in producing the main product. If management has the option of not allowing the second product to emerge from the process the two products cannot be deemed to be joint. Equal Shares Physical Characteristics: The underlying principle in the physical characteristics method is that such characteristics as weight, volume or difficulty to handle cause certain costs to be incurred. Sales Value at Split-Off: The sales value at split-off is the first method to consider the products ability to bear the joint costs, such ability being reflected in money generated by each product for the business. Ultimate Net Sales Value: The ultimate net sales value method is an extension of the preceding method, sales value at split-off. It recognises that the business may wish to process the two products further after the split-off point in an effort to maximise profit. By-products are different from joint products only in terms of motive and commercial value. Joint products are planned for and the production process is designed to cater for them. In such a situation no attempt would be made to allocate the costs of production between the two products; instead the revenues generated from the by-product would be deducted from the costs of processing before determining the gross margin from operations. The type of costing, where individual products are deemed to be separate jobs which incur separate costs, is called job costing. Job costing is operated in enterprises where relatively small numbers of high-value tasks are undertaken during the accounting period, for example in the construction, aerospace, shipbuilding and consultancy industries, or where the outputs can be batched in larger units for costing purposes, for example in the personal computer, motor vehicle and furniture industries. Significant costing problems are encountered by industries where no uniqueness is identifiable in the products produced and where the process is almost continuous, for example the chemical industry or the brewing industry where the units of output are indistinguishable from each other. This type of costing is called process costing. The principle underpinning both job costing and process costing is that of averaging costs incurred over units produced. With job costing the averaging technique is largely reserved for indirect overhead although the valuation of direct material and direct labour can also be subject to averaging. The same principle of averaging underpins process

costing but cost accountants use the notion of equivalent units of production. An equivalent unit of production is an assessment of the degree of completion of a unit under each major component of cost. Activity-based costing (ABC) is a technique currently being explored by some companies and organisations which attempts to combat the deficiencies of traditional costing techniques. The essence of activity-based costing is its focus on the belief that activities (e.g. production planning, quality inspection) rather than products cause costs to be incurred and products consume activities. Activity-based costing focuses on cost drivers those activities or factors which generate cost.

11.

Costs for Decision Making

The form of accounting in which each unit is asked to absorb its share of fixed production overhead, a not-unreasonable requirement, is called full or absorption cost accounting. The form of accounting which accounts for fixed costs in a lump sum is called variable or direct costing. The net profit under full costing and variable or direct costing is identical and, in such circumstances as postulated where actual production equals planned production, and where sales equals production, the managerial insights gained from one method of costing as opposed to the other are limited. But we know that actual production hardly ever matches exactly planned production, and it is rare to find a business where all production is sold by the end of the accounting period. As soon as commercial reality is introduced into the model, the two costing systems produce different numbers. A denominator volume variance arises when actual production planned production. Bottomline profit difference arises when sales actual production. Under variable costing, profit is a function of sales, that is, when sales rise, so do profits. But with absorption costing, profit is influenced not only by sales but also by production levels. By stepping up production beyond sales, management can increase profits because more fixed production expenses are parked in inventory. But this action must inevitably be reversed because of cash flow problems (cash required for production not being restored by sales); when the fixed production expenses come tumbling out of the inventory warehouse under absorption costing, they hit the profit and loss account. It is essential that managements construct a framework within which one-off decisions can be analysed in a thoroughly disciplined manner: Task One: Define the Problem and List All Feasible Alternatives Task Two: Cost the Alternatives: When alternative courses of action are being costed (from both the revenue and cost angles) management is concerned only with the relevant costs, not the total costs, of each alternative. Sometimes a relevant cost is called a differential cost because it is a cost that differs when management changes the scheme of operations. It should be stressed, however, that while the emphasis in examining relevant costs is on variable, or marginal costs, this should not preclude a consideration of fixed costs, too. Task Three: Assess the Qualitative Factors Task Four: Make the Decision By taking a decision to implement a specific option, management automatically forgoes the opportunity of embarking on alternative options. It may be possible to identify certain costs of not choosing one alternative which may be relevant in the decision making process. Accountants are uncomfortable with opportunity costs because (a) these costs cannot be determined from the accounting system and (b) they are highly subjective and uncertain. But managers should make every effort to quantify such costs because they could have a profound impact on the other relevant costs and therefore on the decision to be taken. Relevant cost analysis must not be confused by mixing costs which have been incurred from old decisions with costs which will be incurred in the future. Costs which have been incurred are called sunk costs and should be ignored when looking for relevant costs. Relevant costs are: future costs;

cash costs; avoidable costs; costs which differ among alternatives.

12.

Budgeting

Budgeting has the following attributes: Coordination Planning Motivation Control

A budget is a plan of action, usually expressed in numbers and amounts, that sets targets for individuals and for the business over a defined future timeframe. Planning of a business future, that is strategic planning, must precede the budget exercise. Strategic planning is the managerial exercise that attempts to ensure that a business accomplishes a sufficient process of innovation and change by allocating scarce resources (cash, managerial skill, technological know-how) by adapting to environmental opportunities and threats and by coordinating activities so as to reflect the business strength and weaknesses. Discretionary costs are difficult to budget for and manage because the output is often difficult to measure, budget holders might not be sure of the companies objectives and therefore unsure about where their efforts should be focused, and it might not be easy to control it on an annual basis (e.g. in R&D where a year is a very short timeframe). On technique to ensure that discretionary cost budgets provide sufficient visibility is called zero-base-budgeting (ZBB). In zero-base-budgeting management invites certain activities to bid for their resources as if they were starting from scratch (or from a zero base) instead of adopting the normal incremental approach to annual budgeting. This tool can only be adopted in areas of discretionary expenditure where management must decide the level of expenditure that is appropriate for the business at the current time; with engineered costs, however, the sole criterion of level of spend is the production output required. ZBB involves the analysis of an activity such as R&D or legal services or machine maintenance into packages of work which can be separated from each other, starting with the most fundamental activity and building up to the activity which, were the resources to be made available, it would be beneficial to undertake. These packages of discrete activities are costed and, when placed alongside packages from other discretionary activities, ranked in order of top management priority. Top management must take a view on whether another fully qualified recruit to legal services, to handle the growing problem of intellectual property rights, is more desirable for the company in its current position than another maintenance engineer the addition of whom to the staff of the maintenance department would provide 24hour cover and thereby prevent costly breakdown of machines on the night shift. These decisions are extremely difficult but the secret of ZBB is that the decisions are made by top management and not by budget holders whose vested interests are inextricably bound up with their budget proposals. ZBB also requires corporate functions to identify minimum levels of expenditure below which their activities cannot really operate. New requests for increased spending must be given a priority against existing commitments. Good budgeting procedures shorten the lead time between starting the budgeting exercise and the beginning of the budget period, receive the full backing of top management, and engender a feeling of ownership of the budget numbers among the managers who helped to construct them.

13.

Standard Costing

There can be no better benchmark to judge actual performance than the plan, i.e. the budget, for the period. Management needs detailed costs and revenues of individual components of the business so that corrective action can be taken at the source of the problem. Standard costs are used for this control process. Standard costs are budgeted costs for individual cost items. Put another way, a budget is built up from many standard costs. Standard costs are compared with actual costs and explanations are sought for any differences between the two. The standards for both variable and fixed overhead depend on three components: the budgeted cost of each overhead; the allocation key to be used to allocate overhead to product; and the volume expected of each allocation key to be used.

Variable overhead efficiency variance = (Standard cost of budgeted time for units produced) (Standard cost of actual time taken for units produced) Variable overhead spending variance = (Standard cost of time taken) (Actual costs incurred) Fixed overhead spending variance = (Budgeted fixed overhead) (Actual fixed overheads) Fixed overhead denominator variance = (Budgeted fixed overheads) (Overhead applied to units produced) Material costs can be more (or less) than standard for only two reasons: actual production used more (or less) material than planned, and/or the price to purchase the material was more (or less) than planned.

Material and labour variances can be split into price (or rate) variances and quantity (efficiency) variances; variable overhead variances comprise spending and efficiency while fixed overhead variances can be divided into spending and denominator variances. The calculation of variances represents only one step in variance analysis; seeking explanation for these variances and taking necessary remedial action is the more important function. Only the most significant variances should be investigated. Material efficiency variance = (Standard quantity Actual quantity) x (Standard price per unit) Material price variance = (Standard price per unit Actual price per unit) x (Actual quantity used) An adverse variance is one where actual cost is above standard cost; a favourable variance is one where actual cost is less than standard cost. Labour cost variances are caused by a combination of the same two reasons: actual production requiring more (or less) time than planned; and/or the labour rates actually paid were more (or less) than planned.

Labour efficiency variance = (Standard time allowed Actual time taken) (Standard rate per hour) Labour rate variance = (Standard rate per hour Actual rate per hour) (Actual time taken) Management needs clear, relevant and up-to-date information to control ongoing operations. Variances from budget, in principle, should be of interest to managers; through exception reporting they can learn immediately where there may be problems and take remedial action. The sales quantity variance describes the difference between budgeted and actual numbers of units sold. Sales variance analysis enables the manager to gain detailed insight into total contribution earned from sales and depending on contribution per unit and volume. Sales contribution variance = (Actual contribution margin per unit Budgeted contribution margin per unit) Actual sales in units Sales volume variance = (Actual sales in units Budgeted sales in units) Budgeted contribution margin per unit Sales quantity variance = (Actual sales in units Budgeted sales in units) Budgeted

weighted average contribution margin per unit Sales mix variance = (Actual sales in units Budgeted sales in units) (Budgeted contribution margin per unit Budgeted weighted average contribution margin per unit)

14.

Accounting for Divisions

Advantages for divisions: Specialisation Size Motivation Sharper decisions Career mobility

Disadvantages for divisions: Lack of control Cost Internal rivalries

Types of divisions: Cost centres: Where divisions are held responsible only for the incurrence of cost and have nothing to do with the generation of associated revenues. Revenue centres: Where the exact opposite to cost centres holds, namely where divisions are given the task of generating funds without any reference to the underlying costs or disposition of those funds. Profit centres: Where costs and revenues are matched and divisional performance is assessed on bottom-line profit in the conventional manner. Investment centres: Where divisions net assets are taken into account when evaluating profit performance. In determining the asset base to be used for the performance evaluation the following asset base valuations can be used: Net book value: Net book value is the difference between the original purchase price and the accumulated depreciation. All other things being equal the net book value will decline over time and thus the return in investment will increase. Such a trend might inhibit divisional managers from replacing ageing equipment, although that might be in the long term interest of the company (and the division). Current replacement costs: The most appropriate replacement cost for specific assets is determined and then used as the asset base to evaluate the performance of the return on investment of the division. The subjectivity in determining the replacement costs and the time taken up by such an exercise prevent most companies to employ this valuation technique and tend to use the net book value despite its shortcomings. Using Return on Investment (ROI) as an indicator might lead to dysfunctional behaviour: Assuming a companys cost of capital is 10% but a divisions ROI is 20%, the division might not undertake a project that would bring in 17% ROI because it might water down the ROI of the division although it still would be in the best interest for the company. To overcome the above mentioned problems companies can use residual income (RI) measures. Here each division is charged interest on its invested capital, such interest being set at the rate of the companys cost of capital, and managements goal should be to accept investment proposals which exceed the imputed interest charge. Residual income is expressed in absolute money terms, ROI is expressed in percentages. In measuring divisional performance, well-managed companies avoid relying on only one

indicator such as ROI or RI. Instead they design a matrix of measures which focus on quality, speed of response, customer satisfaction and employee contentment. Criteria for establishing a transfer price: Market prices: Market pricing is by far the best method for transferring goods and services between divisions because it can be objectively tested by both parties to the deal. Cost-based prices: Full costs: When full costs are used, the selling division would calculate the transfer price using variable costs plus a proportion of fixed costs, using the normal absorption formula of the division. Variable costs: From a company point of view the use of variable costs in transfer prices overcomes the shortcomings of using full costs but its use leaves Division A neither up nor down on the deal and it must sit back and watch Division B making all the profit on the ultimate sale. Why should Division A be penalised in this way, particularly if there is a buoyant market for its goods? At the least, they would argue, let us cover our fixed costs by using full costs. Negotiated costs: The term negotiated costs is a delightful euphemism for a managerial punch-up. Behind the need for negotiation lies the reality that market price and cost-based prices have not worked and top management has instructed the two managers to propose a solution which will not harm the company. Such a dual pricing procedure cannot be adopted for a lengthy period of time otherwise the motivation of both divisions, and their confidence in the system, will deteriorate. Determining a transfer price which (a) motivates divisional managers, (b) permits an evaluation of their divisions and (c) leaves them to run their own show as autonomous employees is extremely difficult. A company very often feels obliged to minimise the amount of tax it pays on profits. This has a number of beneficial effects including reducing cash outflows and boosting earnings per share. If transfer pricing can be so geared that the ultimate profit emerges in a tax regime with low rates on corporate profits, the overall tax bill is reduced. Second is the issue of repatriation of profits. Clearly it would be futile for the company in the illustration above to allow its profits to emerge in a tax regime with low rates on corporate taxes if that government refused to allow the company to repatriate the funds by way of cash transfer of dividends. In such a situation transfer prices could be adjusted so that the division located in the restricting country is asked to pay high transfer prices. In this way the cash emerges from the country by way of transfer prices rather than dividends which could be blocked.

15.

Investment Decisions

An investment decision is defined as one whose impact extends beyond the immediate operating period, i.e. the business year. A decision which has its impact within the operating period is defined as an operating decision. In accounting, these terms, particularly for financial reporting, have become synonymous with capital and revenue. In reality, there is often no clear distinction between the two. Investment decisions always require forecasts about the future explicit or implicit and future profits are directly related to the success or otherwise of investment decisions. The investment process involves three quite distinct, albeit related, processes: Search: There is very little that accounting by itself has to offer on the identifying or finding of suitable investment opportunities. This is a separate managerial function and will arise out of the normal managerial processes through perhaps those specifically employed for that purpose. Evaluation: The broad framework will be the organisations strategic plan of where it is, what are its strengths and weaknesses and where it wants to go. Such a plan formal or otherwise will take into consideration environmental and industrial factors, medium- and long-term assessments and financial and operating objectives. This will form the general background against which investments will be judged. In addition potential investments will be judged against some other more specific yardstick of which, in all organisations, profit and/or

cost will be important components. In judging the impact of an investment decision on profit and/or cost the most important concept that is used is that of present value. Control: Once an investment has been undertaken, the financial control of it will follow the normal budgetary control procedures. Present value is the sum which would have to be invested today to amount to a given sum at a rate of interest over a given time period. If n is the numbers of years and i the rate of interest then any sum invested for n years at i per cent will amount to that sum multiplied by (1 + i)n ; the result is referred to as the future value. We can use the reciprocal of the equation, i.e. x/(1 + i)n. This concept of present value, that is, the value today of a sum receivable or payable sometime in the future at a given rate of interest, is one of the most important concepts in all financial calculations which involve different sums over different time periods. It forms the basis of what is popularly known as the discounted cash flow approach to the evaluation of investment opportunities. Discounted cash flow means that when we are dealing with an investment that extends over different time periods we discount the cash flows arising out of the investment down to a present or equivalent value so that we can calculate the profitability and/or cost of it. There are two main techniques which incorporate this principle: Net present value (NPV; sometimes called excess present value or simply present value): The net present value approach takes all the cash flows associated with a project and reduces (discounts) them to a common denominator (present value) by using an appropriate interest rate (sometimes called the cost of capital or the cost of finance). If when all the present values have been added together the resultant total is positive, i.e. there is a positive net present value, then the project is worth undertaking in that it is profitable and has a return which is greater than the interest rate (cost of capital) applied. Discounted cash flow (DCF) rate of return (sometimes called the internal rate of return (IRR) or simply the rate of return): Instead of discounting by the cost of capital we find the interest rate which reduces all these cash flows to zero, that is, the interest rate (rate of return) at which the project will exactly break even. The calculation of the internal rate of return (DCF yield) is easily done using a trial and error approach based in the knowledge that the correct rate of return will give a net present (discounted) value of zero. Both NPV and DCF rate of return are based on the discounted cash flow principle and both give a measure of profitability which takes into consideration the time factor and the need to allow for the recovery of the capital investment over the lifetime of the project. Investment appraisal in non-revenue and not-for-profit situations still can use the concept of NPV to support the reaching of a decision. In this case the NPV is used to compare different options only regarding cost, no cash inflows are expected. Methods to deal with risk in investment decisions are: Do not deal with risks in a quantitative way. The investment estimates are simply developed using the most realistic estimate under the circumstances and the evaluation is performed using the discounted cash flow approach. Apply a high hurdle test, e.g. projects that are regarded to be a high risk project have to pass a higher targeted rate of return for approval. The problem with this approach is that the risk of individual components of the project is not broken out. Payback period is another example of a high-hurdle test. The margin of safety is the amount by which a project can deviate from the targeted estimates before a profit is turned into a loss. The payback period is the time it takes to recover the original investment. The payback period has to be calculated using the properly discounted cash-flows in order to adjust for the time value of money. The weaknesses of using payback period for investment decisions are: that it is implied in the assessment of risk that there is a standard payback period against which the forecast is compared. Although a company might set it (e.g. 5.0 years for low risk projects, 2.5 years for high risk projects), there is no external reference for guidance.

payback looks at the break-even position and ignores the profit that will be generated after break-even. Sensitivity analysis is not an evaluation technique, nor does it enter directly into the evaluation calculation. Rather it is a further analysis which is an aid to management in the exercise of judgement. In its simplest and often most useful form, sensitivity analysis consists of changing the value quantity or price of a key variable to assess the impact which this has on the final result. While sensitivity analysis is a useful device for highlighting the impact of a change in the forecast value of a variable, it does not give, nor build into the evaluation, any indication of the likelihood of such a variation taking place. Profitability may be highly sensitive to variations in the cost of capital but the probability of a change in this variable may be very small. The consideration of this probability of change comes under what is called risk analysis. Risk analysis is about taking this idea of a range of likely values and applying the mathematical techniques of probability analysis to it in order to give a better feel for the riskiness of a project. In the strict mathematical sense, probability, that is, predicting the likelihood or chance of an event, can only be used if there is a history of the event having taken place in identical circumstances on many occasions, or there is the ability to repeat the event on many occasions in identical circumstances such as throwing dice or tossing a coin. When we look at business decisions we can appreciate that there can be no repetition of similar events in identical circumstances. To make this clear we talk about subjective probability. Investment appraisal techniques highlight the key investment factors which are central to the profitability of an investment:

1.

Capital investment: The cash flows will consist of the total fixed and working capital that will be required for the specific project. As far as the amount is concerned it is important that not only the cash outflows associated with the project are included such as the cost of new buildings, plant and equipment, but also the inflows which they may generate. 2. Operating cash flows: These will arise out of the inflows from sales and the outflows from operating expenses. The emphasis is on the word cash because non-cash expenses such as depreciation which are essentially accounting book entries have no part to play in these calculations. Investment appraisal looks at the profitability of a project over its lifetime, not at the allocation of part of this profit to specific time periods such as the accounting year. It is only concerned with the number of years over which the project is to be evaluated, i.e. the investment life. An important factor affecting cash flows is taxation. This will often reduce cash flows, where profits are being made, but equally can often increase cash flows if tax refunds/incentives are available in any particular period. 3. Investment life: Most assets have a finite life and will eventually have to be scrapped or otherwise disposed of. The determinants of this life may be physical, technical or marketrelated. 4. Cost of capital: The cost of capital is a key factor in assessing the profitability of a project and enters the calculations either directly as with the net present value or indirectly as a comparison between the expected return and the DCF rate of return. In projecting the average cost of capital, an organisation is regarded as having a central pool or fund of resources from which all projects are financed. The major sources of longterm finance can be classified under the following headings:

1.

Fixed interest loans such as debentures: The cost of these to the business will be the rate of interest it has to pay on the loans plus an allowance for the cost of raising (servicing) the loan less taxation. 2. Fixed interest (dividend) shares such as preference shares: The cost of these will again be the net interest (or dividend) plus an allowance for the cost of raising it. 3. Residual equity shares: For example a new issue of ordinary shares, rights issues and other non-free issues of ordinary shares. Such sources of finance, unlike the others mentioned above, do not have any predetermined rate of interest or dividend attached to them. It seems reasonable to assume that, if a new issue of share capital is being made, then

the lowest return which will be expected will be one equal to what is being earned at present. The overall earnings per share should not be diluted; thus the company should at least maintain its present value. 4. Retained earnings (profits): The same principle is required when we consider the cost of funds which the business has generated internally through not distributing all the profits it earns. While a dividend does not have to be paid on these, if the relative value of the shareholders interest in the business has to be maintained, these funds should earn at least the same as the existing investment. The investment appraisal techniques at which we have been looking take into consideration the time value of money. This concept of a time value is independent of, and separate from, the question of if, and by how much, the real value (purchasing power) of money changes over time because of inflation (or deflation). If we wish to build an allowance into our calculations for this then it must be done quite specifically.

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Techniques under Development in Management Accounting

Critics of current management accounting spell out its perceived shortcomings in the light of the high-technology environment of modern business: 1. Management accounting procedures are still being driven by the requirements of financial accounting with its emphasis on profit measurement and therefore on inventory valuation. 2. Direct labour as a percentage of total product cost is shrinking, yet despite this, direct labour remains a popular method of overhead allocation, leading, predictably, to allocation percentages running into three figures. 3. Computerised production control, robotic production lines and other technological developments have rendered obsolete some of the traditional assumptions about which costs are variable and which are fixed. 4. As well-managed companies see the potential for differentiating themselves on the basis of quality, customised design and speed of order processing and delivery, a sensible expansion of overheads in these activities is to be encouraged whereas most businesses regard overhead as a burden to be squeezed out from the cost profile as far as possible. 5. The sheer complexity of business has increased exponentially. 6. Global markets accentuate the product difficulties identified above. Competition on price is intense and the demand for a management accounting system to identify accurate product costs becomes more pressing. A cost system based on inventory valuation and financial accounting may not deliver to managers the numbers that will allow the business to sharpen its competitive edge. Target costing has been developed to help companies manage their costs in circumstances when the selling price is known. Equally for an innovator who plans to be the first to market, the target price is set on the basis of the customers perceived value for the product or service and an informed assessment of how much the competition will charge when they catch up. Once the target price is known, the desired profit margin can be deducted in order to determine the target cost beyond which the company would consider it uneconomic to produce and sell the product. Target costs start as global figures (target selling price less target profit margin) and are set for an entirely new model or process. Target costs are usually lower than the existing product costs and therefore the entity is faced with improving its processes in order to meet this tough benchmark. This improvement is known as value engineering which is, in effect, a complete reappraisal of every aspect of the process of manufacture and distribution. Life cycle costing has a future time focus and gathers all revenues and costs associated with a product or service over its whole lifespan so that its ultimate profitability can be measured and management decisions taken thereon. It therefore breaks down two barriers erected by the normal accounting processes: (a) the differentiation between capital and revenue is removed, that is, the purchase of an asset dedicated to a product is viewed alongside the annual costs of manufacture and distribution; and (b) the annual focus of accounting is obliterated as the lifetime revenues are matched against lifetime costs.

Throughput accounting (TA) stresses the fact that products do not earn money, but businesses earn money by selling products. Solutions based on current management accounting fail to recognise the reality of the business situation as looked at from throughput, that is, the rate at which money is earned. Throughput concept I: Depreciation is merely the accounting for a previously incurred cost on fixed assets. Throughput concept II: By treating inventory as something to be driven down and out of a business, management can concentrate on maximising throughput from manufacturing to the customer. This is the link in which profit lies, not in a misguided notion of maximising the efficiency of men, women and machines by producing unwanted inventory. Throughput concept III: Product profitability is the rate at which products earn money, not the method whereby they share costs. These concepts can be put to use in re-examining contribution as a measure of profitability. Proponents use measures of return per factory hour and cost per factory hour in calculating a throughput ratio: Return per factory hour = Sales price Material cost/Time spent at the bottleneck per product Cost per factory hour = Total factory cost/Total time available at bottleneck These two numbers are then combined to give a throughput accounting ratio: Throughput accounting ratio = Return per factory hour/Cost per factory hour A TA ratio under one means that the company is losing money on the product. Costing for competitive advantage or strategic management accounting, according to CIMA, is the provision and analysis of management accounting data relating to a business strategy; particularly the relative levels and trends in real costs and prices, volumes, market share, cash flow and the demands on a firms total resources. The technique of drawing together financial and non-financial indicators of performance in a coherent manner is called The Balanced Scorecard (BSC) and is being adopted by an increasing number of organisations. A balanced scorecard includes financial measures that tell managers the results of actions which have already been taken but adds operational measures on such critical contemporary concerns as customer satisfaction, quality, product and process innovation and the ability of the workforce to come to terms with smarter work habits. TheKaplan andNorton view1 of the balanced scorecardis portrayed in Figure 16.1: The Balanced Scorecard only tracks those KPIs which help management keep on the road towards its strategic goals; typically companies measure significantly fewer balanced scorecard measurements than KPIs. In too many companies the controllers are seen to occupy too central a role in backwardlooking performance measurement and appraisal; with Balanced Scorecard, the role of top management is fundamental and serves to correct the heavy-handed emphasis on looking at the business solely through the financials. Properly managed, the Balance Scorecard puts the companys vision and strategic intent at the heart of on-going managerial debate. Time-based activity-based costing involves managers directly estimating the resource demands imposed by each transaction, product, or customer rather than assign resource costs first to activities and than to products or customers. Under time-based ABC, we require estimates of only two parameters: 1. the cost per time unit of supplying resource capacity, and 2. the unit times of consumption of resource capacity by products, services and customers. The traditional model has difficulty in uncovering idle capacity. The weakness of ABC, together with the relative simplicity of the model, is overcome by employing time measurement: Step 1: Assess the theoretical & practical capacity Step 2: Calculate the cost per hour of supplying capacity Step 3: Estimate the time spent on each unit of activity Step 4: Calculate the cost-driver rates for each activity

Step 5: Calculate the allocated costs per activity using the time-based ABC The proponents of time-based ABC believe that it is transparent, scalable and easy to implement and update.

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A

Glossary
Accounting Accounting is defined as a series of processes and techniques used to identify, measure and communicate economic information which users find helpful in making decisions. It attempts to reflect economic activity in an organisation and is usually expressed in money values. Accounting Equation The accounting equation expresses the relationship between resources and the funds provided to acquire these, i.e. Assets Liabilities = Owners equity. It is a collection of balances after each transaction has been completed and recorded. Note that the accounting entries involve a mixture of cash-driven items and judgement-driven items. Accounting, Financial Financial accounting (or financial reporting) derives from the legal obligation on directors and managers to report to the owners of the business (the shareholders) how they have used the resources at their disposal during the accounting period under review (usually annual). Accounting, Management Management accounting provides the information from the accounting process managers need, e.g. actual and projected costs, prices of individual products, actual and projected costs of individual departments and individual processes, projected sources and uses of cash, proposals for major investment in plant and equipment, and many other details. Accrual Basis of Accounting Financial statements are drawn up on the accrual basis inform users not only of past transactions involving payment and receipt of cash but they also reflect the obligations to pay cash or the prospect of receiving cash in the future. Accruals Convention The accruals convention states that cash does not have to be received to create value; an obligation from a creditworthy customer is good enough to be called a sale. The accruals convention also covers the situation where a sole trader, or company or any other entity pays an invoice for a product or service which covers a period stretching beyond the date he/she draws up the financial statements. The accruals convention is sales-related. Aggregation IAS 1 attempts to indicate the allowed level of aggregation: each material class of similar items must be presented separately; and items of a dissimilar nature of function should be shown separately unless they are immaterial. So if a line item is not individually material it should be aggregated with other items either on the face of those statements or in the notes.

Allocation Convention The allocation convention is a two-step process to is to determine how much of each means of production, expressed in money terms, was consumed during the accounting period and to determine how much of each means of production, again expressed in money terms, should be matched with sales revenue and how much should be added to the closing work-in-progress (inventory of unfinished goods) and to the inventory of finished goods (on the assumption that goods remain unfinished at the end of the accounting period and that the business produces more finished units than it sells). The allocation convention is costrelated. Asset, Contingent Contingent assets are a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the company. Asset, Current Current assets are those assets which are expected to be sold or consumed during the normal operating cycle of the company, usually one year. Typically inventories (raw materials, workin-progress, and finished goods), debtors (increasingly known by its American term accounts receivable) and cash are regarded as being current. Asset, Fixed Fixed assets are those assets that a company keeps for a substantial period of time (like land and buildings or plant and equipment or motor vehicles), not for resale, but to use in the course of business. It is the intention of management as to the use of the asset, not its physical characteristics, that determines whether or not it is classified as a fixed asset. Asset, Intangible Assets are defined as a resource controlled by an entity as a result of past events; and from which future economic benefits are expected to flow to the entity. Intangible assets are a sub-set of this definition and attract a further definition as identifiable non-monetary assets without physical substance. Average Collection Period Average collection period = Trade receivables/Revenues per day; efficiency ratio. B Balance Sheet A balance sheet reports on inventory of resources (fixed assets and current assets) and claims against these resources (liabilities and equity) at a given moment, usually the end of the financial year. Items of expenditure accounted for via the balance sheet we call capital expenditure. Balanced Scorecard (BSC) The technique of drawing together financial and non-financial indicators of performance in a coherent manner is called a Balanced Scorecard. A balanced scorecard includes financial measures that tell managers the results of actions which have already been taken but adds operational measures on such critical contemporary concerns as customer satisfaction,

quality, product and process innovation and the ability of the workforce to come to terms with smarter work habits. Break-Even Point (BEP) The break-even point is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and therefore one has "broken even". A profit or a loss has not been made, although opportunity costs have been paid, and capital has received the risk-adjusted, expected return. C Capital Structure Ratios Capital structure ratios are divided into two groups which are: (a) those that examine the asset structure of the company; and (b) those that analyse the financing arrangements of the companys total assets, in particular the extent to which the company relies on debt. This group of ratios is generally known as the gearing ratios. Cash Flow from Operating Activities The cash generated from the operations of a company, generally defined as revenues less all operating expenses, but calculated through a series of adjustments to net income such as Profit + bad debt provision + depreciation Loss/Gain on sale. Cash Flow Statement Cash flow statements are needed to unstitch the accounting principles which are applied to compile balance sheets and profit and loss accounts and to reveal whether the entity has sufficient cash funds to finance its future operations and its future ambitions for dividend payments to the owners and investments in assets and acquisition of other businesses. Company A company structure avoids the risk of unlimited liability by limiting the liability of the owners (called shareholders) to the amount of equity (called share capital) paid into the company. In the event of legal action being taken against the company, shareholders cannot lose any more money than the sum paid for the shares. Consistency Principle In order to provide a reflection of the affairs on an entity it is essential that readers get presented with information which has been prepared on a consistent basis. This allows the reader to compare this years performance with the previous years. IAS 1 requires entities to stick to its presentation and classifications from one year to another unless there are compelling reasons to change them. A significant acquisition or disposal, or a review of the presentation style, might suggest that a change is required. This change is only permissible if the changed presentation provides information that is reliable and is more relevant to the users and that the revised structure is likely to continue, so that users will be able to compare years performances in the future. Contingency A future event or circumstance that is possible but cannot be predicted with certainty. Control, External An unbiased examination and evaluation of the financial statements of an

organisation, done externally by an outside firm. Control, Internal Internal control is a term used to describe all the various measures taken by the owners and managers of a company to direct and control their employees. Cost Accounting A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step of production as well as fixed costs such as depreciation of capital equipment. Cost accounting will first measure and record these costs individually, then compare input results to output or actual results to aid company management in measuring financial performance. Cost Convention The cost convention allows accountants use the historical (or acquisition) cost of different means of production, that is, the price paid for them by the business when they were acquired. The cost convention is cost-related. Cost of Goods Sold (COGS) A formula to work out the direct costs of your stock sold over a particular period. The result represents the gross profit. The formula is: Opening stock + purchases - closing stock. Costing, Activity-Based (ABC) Activity-based costing is a technique currently being explored by some companies and organisations which attempts to combat the deficiencies of traditional costing techniques. The essence of activity-based costing is its focus on the belief that activities (e.g. production planning, quality inspection), rather than products, cause costs to be incurred and products consume activities (and thereby cause costs). Activity-based costing focuses on cost drivers those activities or factors which generate cost. Costing, Full Under full or absorption cost accounting the full amount of the cost of sales (variable and fixed, direct production related and direct production overhead) are charged against the sales revenue to arrive at the gross profit. Costing, Job Job costing involves the calculation of costs involved in a construction "job" or the manufacturing of goods done in discrete batches. These costs are recorded in ledger accounts throughout the life of the job or batch and are then summarised in the final trial balance before the preparing of the job cost or batch manufacturing statement. Costing, Life Cycle Life cycle costing has a future time focus and gathers all revenues and costs associated with a product or service over its whole lifespan so that its ultimate profitability can be measured and management decisions taken thereon. Costing, Process Process costing is an accounting methodology that traces and accumulates direct costs, and allocates indirect costs of a manufacturing process. Costs are assigned to products, usually in a large batch, which might include an entire month's production. Eventually,

costs have to be allocated to individual units of product. It assigns average costs to each unit, and is the opposite extreme of job costing which attempts to measure individual costs of production of each unit. Costing, Target Target costing has been developed to help companies manage their costs in circumstances when the selling price is known. Target costs start as global figures (target selling price less target profit margin) and are set for an entirely new model or process. Target costs are usually lower than the existing product costs and therefore the entity is faced with improving its processes in order to meet this tough benchmark. This improvement is known as value engineering which is, in effect, a complete reappraisal of every aspect of the process of manufacture and distribution. Costing, Time-Based Activity-Based Time-based activity-based costing involves managers directly estimating the resource demands imposed by each transaction, product, or customer rather than assign resource costs first to activities and than to products or customers. Under time-based ABC, we require estimates of only two parameters: (a) the cost per time unit of supplying resource capacity, and (b) the unit times of consumption of resource capacity by products, services and customers. The traditional model has difficulty in uncovering idle capacity. Costing, Variable Under variable or direct cost accounting the fixed costs of production are accounted for as a lump sum. Cost of Sales A formula to work out the direct costs of your sales (including stock) over a particular period. The result represents the gross profit. The formula is: Opening stock + purchases + direct expenses - closing stock. Also see Cost of Goods Sold. Costs of sales are measured by reference to the valuation of inventory of raw materials, work-inprogress and finished goods at the end of the accounting period. This inventory can be valued in one of a number of ways, each one producing a different cost of sales figure and therefore a different profit figure. Costs, Actual Actual amount paid or incurred, as opposed to estimated cost or standard cost. In contracting, actual costs to date amount includes direct labour, direct material, and other direct charges. Costs, Common Expenses a firm incurs as a whole, and which cannot be assigned directly to any particular department, product, or segment of the business. Costs, Controllable Expenditures that are subject to the discretion of a manager and, hence, can be kept within predefined limits. Costs, Direct Direct costs are the costs of manufacture or preparation, e.g. the purchases of raw materials used, the wages of the workforce

involved in the transformation process, and the costs of using up the equipment, namely depreciation. Costs, Discretionary Cost such as that of advertising, preventive maintenance, research and development, that a manager may eliminate or postpone without disrupting the firm's operations or affecting its productive capacity in the short run. A discretionary cost is usually specific in amount, or is determined by a formula such as a certain percentage of sales revenue. Also called discretionary expenditure or managed cost. Costs, Engineered Costs having a clear relationship to output. Direct materials cost is an example. Costs, Fixed Periodic cost that remains (more or less) unchanged irrespective of the output level or sales revenue of a firm, such as depreciation, insurance, interest, rent, salaries, and wages. While, in practice, all costs vary over time and no cost is a purely fixed cost, the concept of fixed costs is necessary in short-term cost accounting. Firms with high fixed costs are significantly different from those with high variable costs. This difference affects the financial structure of the firm as well as its pricing and profits. The breakeven point in such firms (in comparison with high variable cost firms) is typically at a much higher level of output, and their marginal profit (rate of contribution) is also much higher. Costs, Indirect Indirect costs are items such as advertising and salaries of service support staff. Costs, Non-Controllable Cost not subject to influence at a given level of managerial supervision. For instance, a manager's salary is not within the control of the manager himself. Rent of the factory building is another example. Costs, Period Examples of period costs are selling, distribution and marketing costs, general administrative costs and financial charges. These costs are incurred so that a companys products can be sold, and the money can be collected from the customer, but they typically do not add value to the products unsold at the end of the accounting period. They are therefore written off each year. Costs, Prime Total of direct material costs, direct labour costs, and direct expenses. Costs, Product Product costs can be traced directly to the products being manufactured, or to the production process, e.g. raw materials and labour. In addition to the ones just mentioned we can add various factory overheads such as indirect labour representing wages and salaries earned by supervisors, warehouse staff and maintenance engineers, all of whom do not work directly on the products but whose services are connected to the production process. Other factory overheads would include heat, light and power, supplies and maintenance, depreciation and asset insurances. Costs, Opportunity Opportunity cost is the highest cost of other opportunities foregone. Costs, Standard Standard costs are budgeted costs

for individual cost items. Standard costs are used as target-costs and are developed from historical data analysis or from time and motion studies. Standard costs are compared with actual costs and explanations are sought for any differences between the two. Costs, Sunk Costs which have been incurred are called sunk costs and should be ignored when looking for relevant costs. Costs, Traceable Expenses that can be directly assigned to an activity or cost object on the basis of a cause-and-effect (causal) relationship. Costs, Variable A cost that changes in proportion to a change in a company's activity or business. A good example of variable cost is the fuel for an airline. This cost changes with the number of flights and how long the trips are. Cross-Subsidisation Cross-subsidisation is the practice of charging higher prices to one group of consumers in order to subsidise lower prices for another group. Current Ratio The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better. Current assets/Current liabilities; liquidity ratio. D Debentures A type of debt instrument that is not secured by physical asset or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of bond in order to secure capital. Debt Ratio The debt ratio compares a company's total debt to its total assets, which is used to gain a general idea as to the amount of leverage being used by a company. A low percentage means that the company is less dependent on leverage, i.e., money borrowed from and/or owed to others. The lower the percentage, the less leverage a company is using and the stronger its equity position. In general, the higher the ratio, the more risk that company is considered to have taken on. Total debt/Total assets (gearing ratio); capital structure ratio. Denominator Volume Variance A denominator volume variance arises when actual production planned production. Depreciation Depreciation is the allocation of the cost of assets purchased in one accounting period over the accounting periods in which they are used. Depreciation Methods Straight-line Depreciation, Reducing Balance Depreciation, Consumption Depreciation Discounted Cash Flow (DCF) Discounted cash flow

means that when dealing with an investment that extends over different time periods the cash flows arising out of the investment needs to discounted down to a present or equivalent value so that the profitability and/or cost of it can be calculated. Dividend Cover Dividend cover = Profit from ordinary activities attributable to common stock/Dividend payout; basic stock market ratio Dividend Yield A stock's dividend yield is expressed as an annual percentage and is calculated as the company's annual cash dividend per share divided by the current price of the stock. The dividend yield is found in the stock quotes of dividend-paying companies. Investors should note that stock quotes record the per share dollar amount of a company's latest quarterly declared dividend. This quarterly dollar amount is annualised and compared to the current stock price to generate the per annum dividend yield, which represents an expected return. Dividend per share/Market value per share 100; basic stock market ratio. E Earnings per Share (EPS) EPS measures net income earned on each share of a company's common stock. Net profit/Number of ordinary shares in issue; basic stock market ratio. Efficiency Ratios Efficiency ratios (sometimes referred to as activity or turnover ratios) give an indication of how effectively a company has been managing its assets. F Fair Presentation A fair presentation requires management to select and apply accounting policies (e.g. the depreciation method or the inventory valuation method) which are relevant to the users and are reliable in that they (a) represent faithfully the results and financial position of the enterprise; (b) reflect the economic substance of events and transactions and not merely the legal form; (c) are neutral, that is free from bias; (d) are prudent; and (e) are complete in all material respects. Fixed (Non-Current) to Current Asset Ratio Fixed (Non-current) assets/Current assets; capital structure ratio. G Gearing Gearing (or leverage) is the comparison of a company's long term fixed interest loans compared to its assets In general two different methods are used 1. Balance sheet gearing is calculated by dividing long term loans with the equity (or proprietor's net worth). 2. Profit and Loss gearing: Fixed interest payments for the period divided by the profit for the period. Gearing ratios measure the contributions from shareholders with the financing provided by the companys creditors and other providers of loan capital. Goodwill Goodwill is defined as future economic benefits arising from assets that are not capable of being individually identified and separately

recognised. In effect, on the day of acquisition, goodwill is not valued per se, it is simply the difference between the cost of the acquisition and the net fair value of the assets acquired; it is a residual. Going Concern Principle If management is aware of material uncertainties related to events or conditions that may cast significant doubt upon the entitys ability to continue as a going concern, these uncertainties should be disclosed. The standard requires management to review all available evidence relating to at least the period of twelve months from the balance sheet. Significant doubts about such matters as a collapse in orders, repayment of debt falling due, payment of interest on current debt levels or continuing support of banks and other providers of debt could trigger the need to draw up the financial statements prepared on a basis other than going concern. In practice this would lead to a material write-down of the carrying value of assets in the balance sheet which, in turn would hit the profit and loss account. Gross Profit (GP) Gross profit is calculated as sales minus all costs directly related to those sales. These costs can include manufacturing expenses, raw materials, labour, selling, marketing and other expense. GP measures efficiency of transformation Gross Profit Margin A company's cost of sales, or cost of goods sold, represents the expense related to labour, raw materials and manufacturing overhead involved in its production process. This expense is deducted from the company's net sales/revenue, which results in a company's first level of profit, or gross profit. The gross profit margin is used to analyze how efficiently a company is using its raw materials, labour and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favourable profit indicator. Gross profit/Revenues; profitability ratio. I Impairment A downward revaluation of fixed assets. Income Statement See Profit and Loss Account. Internal Rate of Return (IRR) See Discounted Cash Flow. Inventory Inventory, once physically counted, is valued according to a mixture of cost and conservatism conventions in accounting. Generally, goods in inventory are valued in terms of cost, being the sum of the applicable expenditures and charges directly or indirectly incurred in bringing the article to its existing condition and location. Inventory Turnover Inventory turnover = Cost of sales/Inventory; efficiency ratio. L Liability, Contingent A contingent liability is not recognised as a liability in the balance sheet because it is either only (a) a possible obligation as it has yet to be confirmed whether the company has an obligation that could lead to an outflow of cash; or

(b) a present obligation whose probability of cash outflow is low or for which a sufficiently reliable estimate cannot be made. Liabilities, Current Current liabilities are considered to be those debts owed by the company which it expects to pay within the next 12 months. Under this heading are found such items as creditors, bank overdraft, taxes payable on previously reported profits, dividends payable on previously reported profits, accruals, and deferred revenue (being revenue received by the company in advance of providing the goods or services). Liquidity Cash position Liquidity Ratios Liquidity ratios are designed to measure a companys ability to meet its maturing short-term obligations. A company is in a good position to meet its current obligations if current assets exceed current liabilities by a comfortable margin. M Matching Convention Profit is arrived at by matching the effort (or costs) with the units shipped and invoiced to the customers (sales) during the period. The matching convention is cost-related. Materiality Materiality is defined by IAS 1 as Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged by the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. N Net Present Value (NPV) Net present value is the sum which would have to be invested today to amount to a given sum at a rate of interest over a given time period. In contrast to NPV total present value is the total of the present value for the income stream only, i.e. without the investment being subtracted. Non-Current Asset Turnover Non-current asset turnover = Revenues/Non-current assets; efficiency ratio. O Offset Offset is the practice of deducting one figure from another and publishing the net figure. IAS 1 addresses this practice by stating that companies are obliged to show assets and liabilities, and income and expenses separately. The rule is clear: offsetting must not be undertaken if it detracts from the ability of users both to understand the transactions, other events and conditions that have occurred and to assess the entitys future cash flows. However, it allows the measurement of assets net of valuation allowances such as depreciation and provisions for doubtful debts. One Hundred Per Cent Statement In relation to profitability and cost control a favourite technique

used is the One hundred per cent statement where sales are set at 100 per cent and each item of cost is calculated as a percentage of sales. Owners Equity The owners equity of a company is represented by the net assets (fixed assets + net current assets) of the company. P Partnership In a partnership a number of individuals agree to set up business together, bringing to the partnership assets in varying proportions. As with the sole trader, a partnership need not make public its annual results because its creditors can pursue the partners beyond the limit of their equity in the partnership. Preference Shares Capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. Like common stock, preference shares represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, preference shares pay a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. The main benefit to owning preference shares are that the investor has a greater claim on the company's assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders. In general, there are four different types of preferred stock: cumulative preferred, non-cumulative, participating, and convertible. also called preferred stock. Price/Earnings Ratio (P/E) P/E is the best known of the investment valuation indicators. The P/E is the most widely reported and used valuation by investment professionals and the investing public. The financial reporting of both companies and investment research services use a basic earnings per share (EPS) figure divided into the current stock price to calculate the P/E multiple, i.e. how many times a stock is trading (i.e. its price) per each dollar of EPS. P/E reflects investors' assessments of future earnings. Market price/EPS; basic stock market ratio. Profit Profit is the excess of sales revenue over costs incurred in generating the revenue. Items of expenditure accounted for via the profit and loss account we call revenue expenditure. Profit, Gros The balance of the trading account assuming it has a credit balance. Profit Margin (or Net Profit Margin) The so-called bottom line is the most often mentioned when discussing a company's profitability. While undeniably an important number, investors can easily see from a complete profit margin analysis that there are several income and expense operating

elements in an income statement that determine a net profit margin. It behoves investors to take a comprehensive look at a company's profit margins on a systematic basis. Profit from ordinary activities before taxation/Revenues; profitability ratio. Profit, Net The value of sales less expenses assuming that the sales are greater, i.e. if the profit and loss account shows a credit balance. Net profit before interest and taxes measures managerial efficiency; net profit after interest and before taxes assesses financial structure. Profit and Loss Account A profit and loss account reflects a flow of resources throughout a given period, usually the financial year. Because of various accounting principles embedded in the measurement of accomplishment and the measurement of effort the flows of resources are not measured in terms of cash. Profit or Loss for a Period Unless a standard requires otherwise, all items of income and expense recognised in a period should be included in profit and loss. What this means is that every gain or loss, whether it arose from the normal operations of the business or from the purchase or sale of assets, should be captured in the profit and loss account. A literal interpretation of the standard would also suggest that capital appreciation in non-current assets such as property should also be included but IAS 16 Property, Plant and Equipment reverses this by requiring revaluation gains and losses on property to be taken directly to equity. Profitability Yielding profit or financial gain. Profitability Ratios Profitability ratios are designed to measure managements overall effectiveness. Provision A provision is recognised as a liability (assuming that a reliable estimate can be made) because it is a present obligation and it is probable that an outflow of cash or other resource will be required to settle the obligation. Prudence Principle This principle aims at showing the reality "as is": one should not try to make things look prettier than they are. Typically, revenues should be recorded only when they are certain and a provision should be entered for an expense which is probable. Q Quick Ratio (or Acid Test) The quick ratio is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position. (Current assets Inventory)/Current liabilities; liquidity ratio. R Realisation Convention The realisation convention states that only products that have been sold are

measured as sales. Products which are completed or partially completed and have not realised value for the business are not included. The realisation convention is sales-related. Residual Income (RI) The amount of income that an individual has after all personal debts, including the mortgage, have been paid. This calculation is usually made on a monthly basis, after the monthly bills and debts are paid. Return on Capital Employed (ROCE) The return on capital employed (ROCE) ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company's debt liabilities, or funded debt, to equity to reflect a company's total "capital employed". This measure narrows the focus to gain a better understanding of a company's ability to generate returns from its available capital base. Profit from ordinary activities before taxation/Capital employed; profitability ratio. Return on Equity (ROE) This ratio indicates how profitable a company is by comparing its net income to its average shareholders' equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilising its equity base and the better return is to investors. ROE is expressed as a percentage and calculated as Return on Equity = Net Income/Shareholder's Equity. Return on Inventory Profit from ordinary activities before taxation/Inventory; profitability ratio. Return on Investment (ROI) A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. ROI = (Gain from investment Cost of investment)/Cost of investment or Controllable profit/Net assets. Return on Owners Equity Profit from ordinary activities attributable to shareholders/Owners equity; profitability ratio. Return on Total Assets (ROTA) Profit from ordinary activities before taxation/Total assets; profitability ratio. This ratio is deemed by most companies to be ultimately significant. Revaluation Reserve An accounting term used when a company has to enter a line item on their balance sheet due to a revaluation performed on an asset. This line item is used when the revaluation finds the current and probable future value of the asset is higher than the recorded historic cost of the same asset. S Sensitivity Analysis Sensitivity analysis is not an evaluation technique, nor does it enter directly into the evaluation calculation. Rather it is a further analysis which is an aid to management in the exercise of judgement. In its simplest and often most useful form, sensitivity analysis consists of changing the value quantity or price of a key variable to

assess the impact which this has on the final result. Sole Trader A sole trader can start trading at any time with assets at his disposal. He must, however, distinguish between the transactions that pertain to his business and those that are domestic in nature. In law he has unlimited liability. Because his creditors can pursue him beyond the limit of his business there is no requirement for him to make public his profit and loss account and balance sheet each year. Stock Valuation Methods Straight-line Depreciation, Reducing Balance Depreciation, Consumption Method T Throughput Accounting Throughput accounting stresses that fact that products do not earn money, but businesses earn profit by selling products. Solutions based on current management accounting fail to recognise the reality of the business situation as looked at from throughput, that is, the rate at which money is earned. Times Interest Earned Profit before financial result (=Profit from operations)/Interest charges (gearing ratio); capital structure ratio. U Users, External Shareholders, analysts, creditors, tax authorities, the public Users, Internal Directors, senior executives, managers, employees (and trade unions) V Valuation Methods First In, First Out (FIFO), Last In, First Out (LIFO), Average Method

18.

Abbreviations

A ABC Activity-Based Costing B BEP Break-Even Point BSC Balanced Scorecard C COGS Cost of Goods Sold D DCF Discounted Cash Flow E EPS Earnings per Share F F&W Factory and Warehouse FIFO First In, First Out FGI Finished Goods Inventory G GP Gross Profit I IRR Internal Rate of Return L LIFO Last In, First Out LTL Long Term Loan

M MV Motor Vehicles N NPV Net Present Value O OE Owners Equity P P&E Plant & Equipment P/E Price-Earnings Ratio R RI Residual Income RMI Raw Material Inventory ROCE Return on Capital Employed ROE Return on Equity ROI Return on Investment ROTA Return on Total Assets T TA Throughput Accounting W WIP Work-in-Progress Inventory Z ZBB Zero-Based Budgeting

19.

Formulas
Current Ratio Current Assets/Current Liabilities >2 Liquidity Ratio Quick Ratio (or Acid Test) (Current Assets Inventory)/Current Liabilities >1 Liquidity Ratio Gross Profit Margin Gross Profit/Sales Profitability Ratio Profit Margin Profit Before Interest and Taxes/Sales Profitability Ratio Return on Total Assets Profit Before Interest and Taxes/Total Assets Profitability Ratio Return on Inventory Profit Before Interest and Taxes/Inventory Profitability Ratio Return on Capital Employed Profit Before Interest and Taxes/Capital Employed (Capital employed = Working Capital (Current Assets Current Liabilities) + Fixed Assets) Profitability Ratio Return on Owners Equity Profit Attributable to Shareholders (= Profit After Interest and Taxation)/Owner's Equity Profitability Ratio Fixed to Current Asset Ratio Fixed Assets/Current Assets Capital Structure Ratio Debt Ratio (Gearing) Total Debt/Total Assets Capital Structure Ratio Debt to Equity Ratio Total Debt/Total Equity Capital Structure Ratio Times Earned Interest Profit Before Financial Result (= Profit from Operations = Profit Before Interest and Taxes)//Interest Charges Capital Structure Ratio Inventory Turnover Cost of Sales/Inventory Efficiency Ratio Average Collection Period Debtors/Sales per Day Efficiency Ratio

Fixed Asset Turnover Sales/Fixed Assets Efficiency Ratio Earnings per Share (EPS) Net Profit for the Financial Year (= Profit After Interest and Taxation)//Number of Ordinary Shares in Issue Basic Stock Market Ratio Price/Earnings Ratio (PE Ratio) Market Price/EPS Basic Stock Market Ratio Dividend Yield Dividend per Share/Market Price per Share Basic Stock Market Ratio Dividend Cover Net Profit of the Year (= Profit After Interest and Taxation/Dividend Payout Basic Stock Market Ratio Straight-Line Depreciation (Original acquisition cost - estimated residual value)/Assets service life = Annual charge Consumption Method (Annual running hours/Total number of running hours) Net cost = Annual Charge Valuation of Closing Work-in-Progress and Inventories Beginning inventory + Purchases Ending inventory = Cost of goods sold charged in P/L Account Reducing Balance Depreciation Under this method the depreciation charge will be higher in the earlier years of the life of the asset. Formula see flashcard. Return on Equity (RE) Net Income (= Profit After Interest and Taxation/Shareholder's Equity Return on Investment (ROI) (Gain from investment Cost of investment)/Cost of investment Equation Method to Calculate Break-Even Point Break-even sales = Fixed costs + Variable costs = $ $ Contribution Margin Method to Calculate Break-Even Point Step 1: Contribution margin = Sales price per unit Variable costs per unit (contribution being towards fixed costs) Step 2: BEP = Fixed costs/Contribution margin = x units Contribution Margin Ratio Method to Calculate Break-Even Point Step 1: Contribution margin = Sales price per unit Variable costs per unit (contribution being towards fixed costs) Step 2: Contribution margin/Sales price per unit Step 3 BEP = Fixed costs/Contribution margin ratio = $$ Calculate Sales Required for Defined Target Profit (Fixed costs + Target profit)/Contribution margin Predetermined Overhead Allocation Rate Budgeted overhead for accounting period/Budgeted production units Material Efficiency Variance (Standard quantity Actual quantity) x (Standard price per unit) = $$ Material Price Variance (Standard price per unit Actual price per unit) x (Actual quantity used) = $$ Labour Efficiency Variance (Standard time allowed Actual time taken) (Standard rate per hour) = $$ Labour Rate Variance (Standard rate per hour

Actual rate per hour) (Actual time taken) = $$ Variable Overhead Efficiency Variance (Standard cost of budgeted time for units produced) (Standard cost of actual time taken for units produced) = $$ Variable Overhead Spending Variance (Standard cost of time taken) (Actual costs incurred) = $$ Fixed Overhead Spending Variance (Budgeted fixed overhead) (Actual fixed overheads) = $$ Fixed Overhead Denominator Variance (Budgeted fixed overheads) (Overhead applied to units produced) = $$ Sales Contribution Variance (Actual contribution margin per unit Budgeted contribution margin per unit) Actual sales in units = $$ Sales Volume Variance (Actual sales in units Budgeted sales in units) Budgeted contribution margin per unit = $$ Sales Quantity Variance (Actual sales in units Budgeted sales in units) Budgeted weighted average contribution margin per unit = $$ Sales Mix Variance (Actual sales in units Budgeted sales in units) (Budgeted contribution margin per unit Budgeted weighted average contribution margin per unit) = $$ Net Present Value x/(1 + i) n Net Future Value x(1 + i)n Throughput Accounting Ratio Return per factory hour = Sales price Material cost/Time spent at the bottleneck per product; Cost per factory hour = Total factory cost/Total time available at bottleneck. These two numbers are then combined to give a throughput accounting ratio: Return per factory hour/Cost per factory hour. A TA ratio under one means that the company is losing money on the product.