Fundamentals of Management

Accounting

CIMA BA2

1
 Session 0 Introduction to
BA2

2
Fundamentals of Management Accounting

BA2 leads on to subjects P1 and P2

3
Format of examination paper

A Computer Based Assessment (CBA)

 60 Objective Test Questions
Time allowed – 2 hours

4
Session 1 The context of
management
accounting

5
 The global management accounting
principles

6
Management accounting
Management accounting is ‘the application of the principles of
accounting and financial management to create, protect, preserve and
increase value for the stakeholders of for profit and not-for-profit
enterprises in the public and private sectors.’

Management accounting Financial accounting

•internal focus •external focus
•no legal requirement •required by law
•no set formats or rules •governed by rules and regulations
•main purposes are planning, •purpose is the production of
controlling and decision making statutory accounts

7
Management accounting

8
Characteristics of information
Accurate
Cost beneficial
Complete
Understandable
Relevant
Authoritative
Timely
Easy to use

Term Scope Detail Accuracy View

Strategic Long Wide Summarised Subjective Forecast

Operational Short Narrow Detailed Objective Historic

9
The role of the management accountant
• Strategic planning
• Acquisition of finance
• Improving business systems
• Performance measurement
• Risk management
• Interpreting financial information

10
The finance function

11
CIMA

CIMA
•Established 1919
•World’s largest professional
body of management
accountants
•Committed to upholding the
highest ethical and
professional standards
•Globally recognised as
CGMA

12
 Session 2
Cost identification
and classification

13
Basic terminology

14
Classification of costs

15
Classification of costs by function

16
Classification of costs by element

17
 Classification of costs by nature

Costs which can be easily /

directly traced to a particular
cost object.

Costs which cannot be easily /

directly traced to a particular
cost object.

18
 Direct or Indirect ?
For cost units the distinction between direct and indirect
costs will be:
 Direct Materials are incorporated  Indirect Materials e.g.
directly into the product/service consumables used in production

 Direct Labour physically make  Indirect Labour e.g. production

the product or provide the service supervisor’s Salary

 Direct Expenses are incurred as  Indirect Expenses e.g.

a consequence of making a specific depreciation on production
cost unit – e.g. royalty payment machinery

“PRIME COST” = direct material cost + direct labour cost + direct expenses

19
Classification of costs by behaviour

20
Cost Behaviour
Total
Total
Cost
Cost
Total fixed cost
Total fixed cost
$ $

Total Variable Cost

Total Variable Cost

Output (units) Output (units)

Unit
Unit
Cost
Cost
Fixed cost per unit Variable Cost per unit
Fixed cost per unit Variable Cost per unit
$ $

Output (units) Output (units)

21
 Cost Behaviour

Stepped fixed costs Relevant Range 3

Stepped fixed costs

Total
Cost $ Relevant Range 2

Relevant Range 1

Output (Units)

22
 Cost Behaviour

Semi-variable costs
Semi-variable costs

Total Variable Cost

Cost $ Element

Fixed Cost
Element

Output (Units)

23
1
 Relevant cost
YES
•Incremental costs and revenues
•Future costs and revenues
•Cash flows
•Opportunity costs

NO
•Sunk costs
•Committed costs
•Non cash items
•Net book values
•Notional costs

24
 Session 3
Analysing and
predicting costs

25
Semi variable costs

26
The “High-Low” method
Take highest and lowest levels of output and the associated costs:-

Period Total Cost Output

1 $10,000 10,000
2 $12,000 12,500
3 $8,000 7,500 Lowest Output
4 $17,000 18,750
5 $20,000 22,500 Highest Output

STEP 1:

Variable Cost per Unit = Change in cost $20,000 - $8,000

= $0.80 per unit
Change in output = 22,500 – 7,500

STEP 2:
Fixed costs = $20,000 – (22,500 × $0.80) = $2,000

TOTAL COST = TOTAL FIXED COST + TOTAL VARIABLE COST

TOTAL COST = 2,000 + ($0.80 × UNITS)

27
The scattergraph method

$400

x y = a + bx
Cost $ x

$200 x
a = y axis intercept
x
b = gradient

0
400 units
Output (units)

a = $200

b = Change in Y $400 - $200 $0.50 per unit

= =
Change in X 400 units

Therefore predicted total costs for 1000 units = $200 + ($0.50 x 1000)

28
Regression analysis
Regression analysis finds the line of best fit computationally rather than by estimating
the line on a scatter diagram.

  n∑xy – (∑x)(∑y)  
b= ——————— a = y̅ − b x̅
  n∑x2 – (∑x)2  

where n = number of observations

x̅ and  y̅ are the arithmetic mean (or average) of x and y and are
calculated as:
∑x ∑y

  x̅   =  ——  y̅  = ——
 
n n

29
Correlation
y
io y
n ion
Strong positive Strong negative
Strong positive Strong negative

x x
y ion y ion
io
Perfect positive = ion
n Perfect1positive = Perfect negative = -1
Perfect negative = -1
1

x x
ion ion

30
Pearson’s correlation coefficient
Pearson’s correlation coefficient, denoted r, is defined as:
n∑xy – (∑x)(∑y)
r= ——————————————
  √( n∑x2 – (∑x)2)(n∑y2 –(∑y)2)

r always lies in the range –1 to +1, where:

•r = +1 denotes perfect positive linear correlation

•r =  –1 denotes perfect negative linear correlation
•r = 0 denotes no linear correlation

If we square the correlation coefficient, r, this gives the coefficient of determination, r 2.

The coefficient of determination, r2, gives the proportion of changes in y that can be
explained by changes in x, assuming a linear relationship between x and y.

31
 Session 4
Overhead analysis

32
The 3-Step process
The cost of units of output produced should reflect the full cost of
producing them, therefore all production costs including overheads need
to be included.

A three step process is used:-

STEP 1:- Allocation and apportionment of fixed production

overhead to production department cost centres

STEP 2:- Re-apportionment of overhead collected in

service cost centres (from step1) to production
cost centres

STEP 3:- Absorbing overhead from production cost

centres into cost units using a pre-
determined overhead absorption rate (OAR)

33
Step 1: Allocation and apportionment

Fixed Production Overhead

Production Production Service Cost Service Cost Production

Cost Centre 1 Cost Centre 2 Centre 1 Centre 2 Departments

Allocation: When overhead (such as a cost centre manager’s salary)

can be identified as belonging to a specific cost centre it is
assigned or wholly “allocated” to that cost centre.

Apportionment: Overhead that relates to a number of cost centres (i.e.

factory rent) will be shared or “apportioned” between
those cost centres on an equitable basis.

34
Step 2: Re-apportion service cost centre
overhead

Service cost centre overhead is re-apportioned on the basis of the benefit

provided to the production cost centres.

Production Production Service Cost Service Cost

Cost Centre 1 Cost Centre 2 Centre 1 Centre 2

Typical service cost centres might be:

 Canteen
 Stores
 Maintenance

35
 Reciprocal servicing

Assume the 2 service areas are:

 Canteen
 Maintenance

The canteen may supply services to the maintenance staff, and the
maintenance department may also supply services to the canteen.

In this case we have RECIPROCAL SERVICING

It can be difficult to apportion the service costs in this case as both cost centre
apportion costs to the other.

36
 Reciprocal servicing

Production A Production B Service C Service D

Overhead costs 10,000 25,000 21,000 15,000

after initial
allocation

Use of service
Departments:

Service C 45% 45% 10%

Service D 35% 60% 5%

37
Reciprocal servicing – repeated distribution method
Production A Production B Service C Service D

Overhead costs 10,000 25,000 21,000 15,000

Apportion C 9,450 9,450 (21,000) 2,100

Sub total 19,450 34,450 0 17,100

Apportion D 5,985 10,260 855 (17,100)

Sub total 25,435 47,710 855 0

Apportion C 385 385 (855) 85

Sub total 25,820 48,095 0 85

Apportion D 30 51 4 (85)

Sub total 25,850 48,146 4 0

Apportion C 1 3 (4) 0

TOTAL 25,851 48,149 0 0

38
Reciprocal servicing equation method
C = 21,000 + 0.05D (1)
D = 15,000 + 0.10 C (2)
Insert (2) into (1)
C = 21,000 + 0.05(15,000 + 0.10C)
C = 21,000 +750 + 0.005C
0.995C = 21,750
C = 21,859
So: D = 15,000 + (0.10 ×21,859) = 17,186

Total overhead for A = 10,000 + (0.45 ×21,859) + (0.35 × 17,186) = $25,852

Total overhead for B = 25,000 + (0.45 ×21,859) + (0.60 × 17,186) = $45,148

39
Step 3: Absorption into cost units
Fixed production overhead that have been allocated, apportioned and re-apportioned
into a production cost centre is then absorbed into cost units using a pre-determined
overhead absorption rate (OAR).

Production Production Service Cost Service Cost

Cost Centre 1 Cost Centre 2 Centre 1 Centre 2

OAR 1 OAR 2
Fixed Production Cost Centre Overhead
OAR =
Cost Units QTY of absorption base

Absorption bases commonly used:

 Units produced Note: The OAR is calculated
 Labour hours using the BUDGETED figures
 Machine hours

40
Step 3: Absorption into cost units
During a period overhead is charged or “absorbed” into cost units according to
the predetermined OAR multiplied by the number of units produced. Actual
overhead incurred is likely to be different to the overhead absorbed leading to
an under or over absorption.

(under)/over absorption = overhead absorbed – actual overhead

Budgeted Fixed Production overhead = $60,000 Therefore budgeted OAR

Budgeted Production (units) = 1500 units = 60,000/1500 = $40/unit

During the period actual results were:

Actual Fixed Production overhead = $50,000
Actual units produced = 1200 units

Therefore overhead absorbed:- 1200units X $40 = $48,000

Overhead under-absorbed:- $48,000 - $50,000 = ($2000)

41
 Session 5
Marginal and absorption
costing

42
Treatment of fixed production overheads
The main difference between marginal costing and absorption costing is the treatment of fixed
production costs:

Marginal costing Absorption costing

Product
Period cost
cost

43
Contribution

• Up till now we have measured financial

success using PROFIT:

Profit = Total Sales – Total Costs

(total cost = fixed cost + variable cost)

• Now we are going to use a new measure:

CONTRIBUTION
Contribution = Total Sales – All Variable Costs

44
Contribution
A product has a sales price of $20 and a variable cost of $10 per unit,
therefore Contribution = 20-10 = $10
Consider different production levels:

Units 0 100 500 2000

Total Contribution ($) = 0 1000 5000 20000

contribution per unit x units
Fixed Costs($) (10000) (10000) (10000) (10000)

Profit($) (10000) (9000) (5000) 10000

Contribution per unit 10 10 10 10

Profit per unit 0 (90) (10) 50

45
Marginal costing profit statement
  ABC  XYZ   Total
  $ $ $

Selling price 200 180  

Direct materials 30 50  
Direct labour 40 60  
Variable overheads 10 15  
  –––– ––––  
Contribution per unit 120 55  
× units × 400 × 250  
Total contribution 48,000 13,750 61,750

Less fixed overheads     27,000

      ––––––
Total Profit      34,750
      ––––––

46
Absorption costing profit statement
  ABC  XYZ  Total
  $ $ $

Selling price 200 180  

Direct materials 30 50  
Direct labour 40 60  
Variable overheads 10 15  
Fixed overheads 30 60  
  –––– –––– 
Profit per unit  90 (5) 
  × 400 × 250 
  –––– –––– 
Total profit  36,000 (1,250) 34,750
  –––– ––––  ––––––

47
Reconciling marginal and absorption costing
In cases where we produce more or less that we sell in a period, inventory
levels will change and the profits under marginal and absorption costing will
differ.

• If inventory levels increase, absorption costing gives the higher profit.

This is because in absorption costing, fixed overheads held in closing
inventory are carried forward to the next accounting period instead of being
written off as a period cost in the current accounting period as in marginal
costing.

• If inventory levels decrease, marginal costing gives the higher profit.

This is because fixed overhead brought forward in opening inventory is
released, thereby increasing cost of sales and reducing profits.

• If inventory levels are constant, both methods give the same profit. 

48
Reconciling marginal and absorption costing

$
Absorption costing profit X

Change in inventory × OAR X/(X)

––––––

Marginal costing profit X

 ––––––

49
Pricing decisions

50
 Session 6 Budgeting

51
Purposes of budgeting

52
Preparation of functional budgets
Sales budget (units)

Adjust for changes in inventory levels

Production Budget (Units) Labour Budget

multiplied by materials usage per unit

Materials usage Budget

Adjust for changes in inventory levels

Materials Purchases Budget

53
Adjusting for changes in the level of inventory

Opening inventory + Production = Units sold + Closing inventory

Production (units) = Units sold + Closing inventory - Opening inventory

Materials used (kgs) = Production units x kgs/unit

Purchases (kgs) = Materials used + Closing inventory - Opening inventory

54
Cash Budgets

Month 1 Month 2 Month 3

Receipts
Receivables X X X
Cash Sales X X X
Loan X
X X X
Payments
Trade Payables X X X
Cash Purchases X X X
Fixed Assets X
X X X

Net Cash Flow X X X

Add: Opening Balance X X X

Closing Balance X X X

55
Phasing of Sales Receipts

Month 1 Month 2 Month 3 Month 4

Sales $40,000 $35,000 $47,000 $60,000

Invoices paid in month of sale 60% 60%

Invoices paid one month later 25% 25%
Invoices paid two months later 15% 15%
100%

56
 Flexed Budgets

Fixed Flexed Actual

Budget Budget Results Variance

10,000 units 12,000 units 12,000 units

$ $ $ $
Sales 200,000 240,000 235,000 (5,000)

Direct Materials 20,000 24,000 24,600 (600)

Flex
Direct Labour 60,000 72,000 70,000 2,000
Admin Costs 10,000 10,000 11,000 (1,000)
Selling and Dist 30,000 30,000 28,000 2,000

Compare
Profit 80,000 104,000 101,400

Volume Variance Budget Variance

Variable costs are flexed to the actual volume produced and sold to allow
meaningful comparison to actual results

57
 Methods of budgeting

• Rolling budgets
• Periodic budgets
• Zero-based budgeting
• Incremental budgeting
• Participative budgeting
• Imposed Budgeting
• Activity based budgeting

58
 Session 7 Standard costing
and variance analysis

59
Standards
What is a standard ?

CIMA describes it as a “benchmark measurement

of resource usage or revenue or profit generation,
set in defined conditions”

Types of standard
 Basic Standard
 Ideal Standard
 Attainable Standard
 Current Standard

60
Standard Cost

Standard Cost: a predetermined unit cost or a budget for one unit

Standard Cost Card for Product X:

Direct Materials: 2kgs @ $3 per Kg 6.00

Direct Labour: 1.5hrs @ $7.00 per hr 10.50
Prime Cost 16.50
Variable overhead: $2 per labour hour 3.00
Marginal Cost 19.50

Note: The standard cost per unit for each cost element has two aspects – a standard price
of input resource and standard usage per unit of product

61
Variable cost variances

62
Material variance

With reference to the previous Standard Cost Card:

Material: 2kg x $3 = $6 – this is what we expected to pay for each unit

If the company actually made 1000 units in the period, and bought 1950kgs of
material costing $5694, calculate the material variances.

First calculate the total Material Cost Variance:

If each unit should cost $6, 1000 units should have cost $6000
The actual cost was $5694
The total material variance is $306

The company paid LESS than they expected, so it is a

FAVOURABLE variance, we write it as: $306 F

63
 Material variance
Now we can split the total variance into Price and Usage.

Set out the calculations as follows:

Price

1950kg should have cost $5,850

Did cost $5,694
Material price variance $ 156 F

Usage

1000 units should have used 2,000 kg

Did use 1,950 kg
Usage variance in kg 50 kg F

X standard price x $3
Material usage variance $150 F

64
 Labour Variance
The labour variance and Variable overhead variances are calculated in a
similar way:
Assume the actual labour cost was $10,200 and 1,600 hours were worked.

Labour Rate

1,600 hours should have cost $11,200

Did cost $10,200
Labour rate variance $ 1,000 F

Labour efficiency

1000 units should have used 1,500 hours

Did use 1,600 hours
Efficiency variance in hours 100 hours A

X standard price x $7
Labour efficiency variance $700 A

The total labour variance = $300 F

65
 Variable Overhead Variance
Assume the actual variable overhead cost was $3,500.

Variable overhead expenditure

1,600 hours should have cost $3,200

Did cost $3,500
Variable oh expenditure variance $ 300 A

Variable overhead efficiency

1000 units should have used 1,500 hours

Did use 1,600 hours
Efficiency variance in hours 100 hours A

X standard price x $2
Variable oh efficiency variance $200 A

The total labour variance = $500 A

66
Sales Variances

67
 Sales Variance
A company budgeted to sell 580 units but actual sold 620 units. The
standard selling price was $13/unit but the actual selling price was
$16/unit. The variable costs were budgeted at $4/unit but were $6/unit.
Sales price variance

620 units should have sold for $8,060

Did sell for $9,920
Sales price variance $1,860 F

Sales volume contribution variance

Actual sales volume 620 units

Budgeted sales volume 580 units
Variance in units 40 units F
X standard contribution x $9
Sales volume contribution variance $360 F

The total sales variance = $2,220 A

68
Reconciling Actual with Budgeted Contribution

$
Budgeted Contribution X
Sales Volume Variance X

Actual Sales volume @ Standard Contribution X

Sales Price Variance X

Total Cost Variances X

Actual Contribution X

69
Interpreting variances
If materials are of a higher quality than standard
this may result in:

 Adverse materials price variance

 Favourable materials usage variance

If employees are more highly skilled than allowed

for in standards this may result in:

 Adverse labour rate variance

 Favourable labour efficiency variance
 Favourable materials usage variance
 Favourable variable overhead efficiency variance

70
 Session 8 Integrated accounting
systems

71
 Integrated Accounting Systems – basic explanation

Materials, Labour &

Expense Control A/Cs WIP Control a/c Production O/H Control

xxxxxxx 1 1 xxxxxxx xxxxxxx 4 2 xxxxxxx xxxxxxx 3

xxxxxxx 2 3 xxxxxxx 7 xxxxxxx xxxxxxx 7

Finished Goods a/c Cost of sales a/c Statement of profit or loss

4 xxxxxxx xxxxxxx 5 5 xxxxxxx xxxxxxx 6 6 xxxxxxx

7 xxxxxxx 7 xxxxxxx

1) Direct Costs (materials, labour, expenses) consumed are charged to WIP

2) Indirect Costs are charged to the Production Overhead control account as they are consumed
3) Overhead is absorbed into units of finished goods produced
4) Cost of finished goods produced is charged to the Finished Goods Control a/c

5) Cost of finished goods sold is charged to the Cost of Sales a/c

6) Cost of sales is charged to the Statement of profit or loss

7) Under/over-absorption is charged to the Statement of profit or loss

72
Standard Cost Book-keeping

Variances will be recorded in the cost accounts as follows:

 Price, rate and expenditure variances are recorded

within the relevant cost ledger accounts (materials,
labour and overheads control) and the WIP account is
charged with the standard cost of actual resources
used.

 Efficiency and usage variances are recorded in the WIP

control account, so that finished goods stock is valued at
standard cost.

73
Recording the Materials Price Variance
1000kgs of material is purchased @ $5 on 1st March and issued to production at
the standard cost of $6 on the 10th March.

1) Where Inventory is valued at Actual Cost:

Materials Control Account

1st March Purchases $5000 10th March WIP Control a/c $6000
10th March Price Variance $1000

Price variance calculated on

issue to production 10th March
– credited to variance a/c

2) Where Inventory is valued at Standard Cost:

Materials Control Account

1st March Purchases $5000 10th March WIP Control a/c $6000

1st March Price Variance $1000

Price variance calculated on

receipt into stores 1 st March –
credited to variance a/c

74
Recording variances in WIP Control

If the standard usage for producing the actual quantity of finished

goods was 900 kgs (but 1000kgs were actually consumed) then the
entries in the WIP control a/c would be:

WIP Control Account

1 10th March Raw Materials Control 12th March finished goods Control $5400 2
$6000

12th March Materials usage variance $600 3

1 Actual Raw Materials used at Standard Price

2 Standard Raw Materials usage at Standard Price

3 Material Usage Variance – debited to Variance a/c

75
 Session 9
Performance
measurement

76
Responsibility accounting
• Cost centre managers might be interested in assessing the costs
incurred by a particular responsibility centre within their area.

• Revenue centre managers might be interested in assessing the

revenue generated by a particular responsibility centre within their
area.

• Profit centre managers might be interested in assessing the

profitability of a particular product or service, in which case, costs
might be classified by nature so that they can be traced to individual
products or services.

• Investment centre managers will be interested in assessing the

return being made by a product or service centre in relation to the
capital outlay for that product or service.

77
Financial measurements
• Gross revenue = total sales

• Contribution = sales revenue − variable costs

• Gross margin = sales revenue − direct production or purchasing

costs

• Gross margin % = gross margin ÷ sales revenue

• Net (operating margin) = gross margin − overheads

• Net (operating margin) % = net (operating) margin ÷ sales revenue

• Return on capital employed (ROCE) = profit before interest and tax

÷ capital employed

78
Non-financial measurements
Non-financial measures are often grouped together into the broad headings of
productivity or quality

Examples of non-financial performance measures for different business areas:

Department Measure

 Production department  Meeting emissions targets

 Level of wastage

Sales  Number of new customers

   Staff cost per customer

Call centre  Number of abandoned calls

   Average length of time of calls

 Distribution centre  Accuracy of delivery   

 Average speed of delivery   

79
Balanced scorecard

80
Service organisations

• Intangibility. Services cannot be packaged for the

customer to take away with them.

• Variability. Each service is unique and cannot

usually be repeated in exactly the same way.

• Simultaneous production and consumption.

Services are often created by the organisation at
the same time as they are consumed by the
customer.

• Perishability. Services cannot be stored for later.

81
Service organisations

Composite cost units can be suitable for service

organisations:

Hotel — bed-night or room-night

Hospital — in-patient day
Haulage contractor — tonne-kilometre

   Total cost incurred in period

 Average cost per units of service =  ——————————————————

 Units of service supplied in the period

 

82
 Session 10
Preparing accounts and
reports for management

83
Specific Order Costing

Specific Order Costing:

Job Costing

Batch Costing

Goods are produced to specific customer order and are heterogeneous

84
Job Cost sheet - example

85
Specific Order Costing

Batch costing:

The CIMA Terminology defines a batch as a ‘group

of similar units which maintains its identity
throughout one or more stages of production and is
treated as a cost unit’. An example would be a
batch of printed leaflets. 

86
Controllability

A performance measure will be particularly relevant if it is

controllable by the manager for whom the report is
prepared, that is if the manager is able to take action to
influence the measure, and if an improvement in the
performance measure would improve the performance of
the responsibility centre or the organisation overall.

It is important to remember that an item that is

uncontrollable for one manager could be controllable by
another.
In the long term, all costs are controllable.

87
Reports in different organisations
Manufacturing:

•Product contribution analysis

•Gross margin analysis

Service:

•Composite cost units

•Cost per unit of service

88
Example (with contribution)

Product A Product B Product C Total

Sales Revenue 913 244 954 2,111

Variable Costs 610 148 618 1,376

Contribution 303 96 336 735

Fixed Costs 102 110 125 337

Profit 201 (14) 211 398

On the basis of profit alone Product B might be discontinued – but if fixed

costs do not change overall contribution and profit would reduce

89
Reports in not-for-profit organisations
Not-for-profit organisations include:

•charities
•educational establishments
•government bodies

Main problems:

•the problem of identifying and measuring objectives         

.
•the problem of identifying and measuring outputs

Three Es:

•Economy

•Efficiency

•Effectiveness

90
 Session 11
Risk 1: Summarising
and analysing data

91
Risk and uncertainty

RISK:
The term 'risk' is used to describe a scenario when we know
the different possible outcomes and can estimate their
associated probabilities

UNCERTAINTY:
The term 'uncertainty' is used when we do not know the
possible outcomes and/or their associated probabilities.
Uncertainty is essentially a matter of ignorance. The future
cannot be predicted because there is insufficient information
about what the future outcomes might be. Decisions under
conditions of uncertainty are often a matter of guesswork .

92
Tabulating data
• Tallying - set up the range of outcomes in a list and putting a notch
against each number each time it appears in the data. These notches
are normally shown in groups of five making it each to count the totals
at the end.

• Grouped distributions - tally the number of values in a certain range

or class.

• Cumulative frequency distributions - these are the number of data

values up to (or up to and including) a certain point. They can easily be
compiled as running totals from the corresponding frequency
distribution.

93
 Charts and diagrams
Pie Charts Bar Charts
$
50
40
30
20
10
0
J F M A
Histograms
Ogives
Frequency
Cumulative
500
Frequency 500
400
400
300
300
200
200
100 100
0 0
10 20 30 40 50 60 10 20 30 40 50 60
Time (minutes) Time (minutes)

94
Averaging data
• Mean - the value obtained by dividing the sum of the values in question
by the number of values.

• Median - the middle of a set of values.

• Mode - the value that occurs most often in a set of data.

EXAMPLE:

8, 10, 1, 4, 5, 7, 4, 3, 13, 5, 4, 8

Mean = (8+10+1+4+5+7+4+3+13+5+4+8) ÷ 12 = 6

Median: 1, 3, 4, 4, 4, 5, 5, 7, 8, 8, 10, 13 = 5

Mode = 4

95
Measures of spread

Standard deviation
______________
Mean

96
 Session 12
Risk 2: Probability

97
.
Basic probability
A probability expresses the likelihood of an event occurring.

• If an event is certain to occur, then it has a probability of one.

• If an event is impossible, then it has a probability of zero.

• For any event, the probability of it occurring must lie between zero and one.

• The higher the probability is, then the more likely it is that the event will happen.

• In any given scenario, the probabilities associated with all possible outcomes must add
up to one

Total number of outcomes which constitute the event

_________________________________________
• Probability (event) =
Total number of possible outcomes

98
.
Types of probability

• Exact - These can be applied to the population of outcomes, e.g. the probability of a
certain card being drawn from a pack of cards

• Empirical - These can be calculated from samples of observations from the past, e.g.
the probability of a certain level of sales occurring in a day

• Subjective - These are based on judgement, e.g. the probability of winning a new
order, or finding oil in a new drilling area

99
Probability tables
A company has 100 customers.

45 are from country A and 55 from country B

25 are small customers and 75 are large.
15 of country A customers are large.

We can set up a table showing all the possibilities:

Country A Country B Total

Large 15 10 25
Small 30 45 75
45 55 100

The probability of a large customer = 25 ÷ 100 = 0.25 = 25%

The probability that a small customer is from country B = 45 ÷ 75 = 0.6 = 60%

100
Expected value
An expected value is a long run average

EV = ∑PX

Where: X is the outcome and P is the probability of the outcome.

EXAMPLE:

Condition Sales ($000) (X) Probability (P) PX

Good 250 0.2 50
Fair 180 0.5 90
Poor 90 0.3 27
Expected value 167

101
Probability trees

Repay 0.95
$50
A

High Not repay 0.05

loan
($200)

C
Refuse

Repay 0.95
$20
Low loan B

Not repay 0.05

($30)

102
Normal distribution
• The mean is shown in the centre of the diagram.
• The curve is symmetrical about the mean. This means that 50% of the values
will be below the mean and 50% of the values will be above the mean.
• The mean, median and mode will all be the same for a normal distribution.  
• The total area under the curve equals 1.
• The standard deviation shows how far the values spread out from the mean

Mean

Frequency
distribution

Standard deviation

103
Normal distribution Mean

-3 -2 -1 0 1 2 3

Standard deviation
If we think of a standard normal distribution curve with three standard deviations, the
following will be true:

•In general 68% of values are within one standard deviation (between -1 and 1)

•95% of values are within two standard deviations (between -2 and 2)

•99.7% of values are within three standard deviations (between -3 and 3).

104
Normal distribution
To use the normal distribution we first have to convert our normal distribution to a
standard normal distribution.

A standard normal distribution has:

•a mean of 0
•a standard deviation of 1

x–µ
This special distribution is denoted by z and can be calculated as: ______________
σ
Were:
•z is the z score
•x is the value being considered
•μ is the mean
•σ is the standard deviation

Once we have calculated our ‘z score’ we can look this up on the normal
distribution table to find the area under the curve, which equates to the percentage
chance (probability) of that value occurring.

105
 Session 13
Short-term decision
making

106
 Relevant cost of material

Are materials already in inventory? No Purchase price

Yes

Will they be replaced?

Yes Replacement cost

No
Net realisable value
No
Can they be used for other
purposes?

Yes Opportunity cost

107
 Relevant cost of labour

Does spare capacity

Yes
exist? Nil

   

No
Opportunity cost
No
Can extra labour be
hired?

 
Yes
Cost of hiring

108
 Relevant cost of non-current assets

Will asset be replaced?

Yes
Replacement cost
 
 

No

Net cash flows from the use

No of the asset
Will asset be sold?

Yes
Net realisable value

109
 Contribution to Sales ratio
Contribution to Sales Ratio (C/S ratio)
= (Contribution per unit) / Unit Sales Price

Example: Details for Product A:

Sales $50
Direct Material $10
Direct Labour $15
Fixed Overhead $5 (Total fixed overhead $20,000)
Calculate the contribution and the C/S ratio.

Contribution = 50-10-15 = $25

C/S ratio = 25/50 = 50%

110
 Break-even analysis

B/E Point (units) = Fixed Costs

Contribution per
Unit

B/E Point ($) = Fixed Costs

C/S ratio

From previous example (Product A), calculate the breakeven in units

and in sales revenue
Breakeven (units) = 20,000/ $25 = 800 units
Breakeven ($) = 20,000/50% = $40,000

111
 Break-even analysis

Sales for a certain level of profit = Fixed Costs + Required Profit

Contribution per Unit

Sales revenue for level of profit = Fixed Costs + Required Profit

C/S ratio

From previous example, assume the company needs to make $50,000 profit,
calculate the required sales in units and in $ revenue
Sales required for $50,000 profit = (20,000+50,000)/$25 = 3000 units
Sales revenue required for $50,000 profit = (20,000+50,000)/50% = $150,000

112
The Margin of Safety

Margin of Safety = Budgeted Sales – Breakeven Sales

Margin of Safety (%) = Budgeted Sales – Breakeven Sales

Budgeted Sales

From previous example, the budgeted sales of Product A were 1,500

Margin of Safety (units) = 1,500 – 800 = 700 units
Margin of Safety (%) = (1,500-800)/1,500 = 46.7%

113
 Basic Breakeven chart
Sales Revenue

$’000
fit
Breakeven point Pro
l C o sts
40 Tota

30

20
s Fixed Costs
Los

0
10 20 30 40 50 60 70 Number of units

114
 Break-even analysis

Breakeven point:
The point where total costs
Breakeven nu
e = total sales revenue
e
Point Rev and
les osts
a To tal C Where there is neither a
$ S
profit or loss

Fixed Costs

Output (units)

The diagram is known as The Break-even chart

115
The Margin of Safety

l Co sts
Tota
£

Fixed Costs

Margin of safety

Breakeven Budgeted
Output Output

The Margin of Safety represents the level by which output can

fall before the organisation makes a loss

116
 Contribution Breakeven chart
Sales Revenue

$’000
fit
Breakeven point Pro

al C osts Contribution
Tot
Fixed
Costs

ss
Lo Variable Costs

10 20 30 40 50 60 70 Number of units

117
 The Profit-Volume Chart
The profit-volume chart presents information in a way that clearly
shows the change in the level of profit – using data from the previous
data table:
Profit

+$5000

0
Output
1000 1500

-$10000

Loss

118

Page 30
Limitations/Assumptions of CVP

 Costs behaviour is assumed to be linear

 Revenue is assumed to be linear
 Volume Produced = Volume Sold
 Ignores inflation
 Assumes a constant sales mix

119
 Limiting Factor Analysis

A limiting factor is a factor of production that is in short supply to the extent

that sales demand cannot be met. Under these circumstances the approach is
to maximise the contribution per unit of limiting factor.

The 5-step approach:

STEP 1: Identify the limiting factor

STEP 2: Calculate the contribution per unit

STEP 3: Calculate the contribution per unit of limiting factor

STEP 4: Rank the products

STEP 5: Prepare the optimum production plan

120
Make or buy decisions

Internal manufacture cost V External bought in price

• If external cost cheaper – buy in

• If internal cost cheaper – make in house
• Need to use relevant costs in decisions
• May be limiting factors

Internal manufacture cost is the variable production cost

121
 Session14
Long-term decision
making

122
The capital investment process
To appraise a potential capital project:

•Estimate the costs and benefits from the investment

•Select an appraisal method and use it to assess if the investment
is financially worthwhile
•Decide whether or not to go ahead with the project

EXAMPLE:

An investment costs $400,000

Estimated cash inflows: $150,000 per annum for four years

Company uses a 10% cost of capital

123
Payback calculation
YEAR Cash flow ($000) Cumulative cash flow ($000)
0 (400) (400)
1 150 (250)
2 150 (100)
3 150 50
4 150 200
Payback = 2 Years + (100 ÷ 150) months = 2 years 8 months.

Constant annual cash flows:

As the investment as constant annual cash flows, the calculation can
be done as follows:
Initial investment 400,000
Payback = ______________ = _______ = 2.667 years = 2 years 8 months
Annual cash flow 150,000

124
Payback

125
Time value of money
Money received today is worth more than the same sum received in the future,
i.e. it has a time value.

Compounding:
Present value Future value

V = X(1+r)n V = Future value

X = Initial investment (present value)
r = Interest rate
Discounting:
Present value Future value

X = V(1+r)-n (1 + r)–n is known as the discount factor

126
NPV calculation
• Convert all future cash inflows into present value terms

• Deduct the initial investment

This tells us the impact the project has on shareholder wealth.

YEAR Cash flow ($000) Discount Present value

factor (10%) ($000)
0 (400) 1 (400.00)
1 150 0.909 136.35
2 150 0.826 123.90
3 150 0.751 112.65
4 150 0.683 102.45
––––––
NPV = 75.35

127
NPV with constant cash flows
Where there are constant cash flows for a set number of years, annuities can be used:
YEAR Cash flow ($000) Annuity factor Present value
(10%) ($000)
0 (400) 1 (400.00)
1-4 150 3.17 475.50
––––––
NPV = 75.50

Where there are constant cash flows indefinitely, perpetuities can

be used:

PV = Annual cash flow × Perpetuity factor

1
Perpetuity factor = ––––––
r

128
NPV

129
IRR calculation
Calculate the NPV at two different discount rates:

YEAR Cash flow Discount Present Discount Present

($000) factor value factor value
(10%) ($000) (20%) ($000)

0 (400) 1 (400.00) 1 (400.00)

1 150 0.909 136.35 0.833 124.95
2 150 0.826 123.90 0.694 104.10
3 150 0.751 112.65 0.579 86.85
4 150 0.683 102.45 0.482 72.30
–––––– ––––––
NPV = 75.35 (11.80)
Then use the formula:
NL 75.35
IRR = L + –––––– (H − L) = 10 + –––––––––– (20 − 10) = 18.6%
(NL − NH) (75.35 +11.80)

130
IRR with constant cash flows
Set the NPV to zero and using the cumulative present values tables to
‘work backwards’ to work out the discount rate
YEAR Cash flow ($000) Annuity factor Present value
(10%) ($000)
0 (400) 1 (400)
1-4 150 2.667 400
––––––
NPV = 0

The annuity factor used must be = 400 ÷ 150 = 2.667

Look along the year 4 row to the annuity factor closest to 2.667

IRR lies between 18% and 19%

Annual cash flow

For perpetuities the following formula can be used: IRR = ______________
Initial investment

131
IRR

NL
IRR = L+ x (H - L)
NL - NH

132
Discount factors
Changing discount rates:
Discount rates might change from year to year. In these instances we must calculate
each year's discount factor individually using the discounting formula.
EXAMPLE:
  Calculation Discount factor
Year 1: 10% Year 0   1.000
Year 2: 12% Year 1 1.000/1.10 0.909
Year 3: 15% Year 2 0.909/1.12 0.812
Year 4: 16% Year 3 0.812/1.15 0.706
Year 4 0.706/1.16 0.608

Non-annual periods:
In some instances we may have to deal with cash flows which are not in annual terms.
For example, costs might be paid monthly or in 6 monthly blocks.
If we are given an annual discount rate, the formula for changing to a non annual rate:

(1 + annual rate)(1 / number of periods) – 1

133