1. Introduction1. Introduction

• Accounting is a series of processes and techniques used to identify, measure and communicate economic information, in support of making business decisions.

• Internal users: directors, senior executives, managers and employees.

• External users: shareholders, analysts, creditors, tax authorities, the public

The Accounting EquationThe Accounting Equation

• Balance Sheet: Assets – Liabilities = Owner’s Equity

• The British convention is to organize the balance sheet as: Fixed Assets + Net Current Assets = Owner’s Equity – Creditors

• Owner’s Equity is described as Capital Introduced +/- Profits earned (and retained)

DefinitionsDefinitions

• Fixed assets + net current assets = Owners’ equity + long-term debt

• ‘Current’ is used in the sense that the assets or liabilities are expected to be converted to cash on the next operating period.

• ‘Fixed assets’ are relatively long life (more than the current operating period) and used in production rather than being for resale.

More definitionsMore definitions

• Items of expenditure accounted for on the Profit and Loss Account (= Income Statement) are called revenue expenditure. Those accounted for on the Balance Sheet are called capital expenditure.

• A third accounting statement, the Cash Flow Statement, portrays only those economic events of a business that affect cash flows.

Cash Flow StatementCash Flow Statement

• Shows sources and uses of cash.• The first source of cash should be the

operations of the business.• Items charged in the profit and loss account

that did not affect cash – such as depreciation – are added back in.

• An increase in creditors is a source of cash; the reverse is true of an increase in debtors.

Financial ReportingFinancial Reporting

• Financial reporting derives from the legal obligation on directors and managers to report to the owners of the business (shareholders) how they have used the resources at their disposal during the accounting period under review (usually one year).

2. Profit and Loss Account2. Profit and Loss Account

• Profit is the difference between the sales made during the period and the costs (direct and indirect) incurred to bring the goods sold to the market place ready for sale.

• Accomplishment for the accounting period is measured by the number of products shipped and invoiced to customers: sales or turnover.

AccomplishmentAccomplishment• Accomplishment is generally measured at the first

point in the operating cycle that the following conditions are satisfied:

• The principal revenue-producing service has been performed.

• All costs have been incurred or remaining costs are either negligible or highly predictable.

• The amount ultimately collectable in cash can be estimated within an acceptable range.

• The time of shipping and invoicing is typically the first that these criteria have been met.

Accounting ConventionsAccounting Conventions• Realization Convention: Only products that have actually

(and not prospectively) been sold are measured as sales.• Accruals Convention: Revenues and expenditures are

recognized in the periods that the corresponding production effort is made.

• A credit sale made this period is accrued to sales, even if payment does not occur until the next period.

• A tax liability on profits is accrued for this period, even if not payable until the next period.

• A lease payment that covers portions of this period and next period is accrued accordingly.

Measurement of EffortMeasurement of Effort• Matching Convention:

• Profit is arrived at by matching the costs to the units shipped and invoiced (sold) during the period.

• Allocation Convention:• How much of each means of production was consumed in

the present period and how much remains?• Of that consumed, how much is attributable to sales and

how much to work in progress?• Cost Convention:

• These use the historical (or acquisition) costs of the means of production.

DepreciationDepreciation

• Depreciation, by itself, does not provide cash for the replacement of assets.

• Cash cost was incurred in advance. This is afterward an exercise in allocation.

• The periodic charge for depreciation is calculated having regard to three factors:

• Acquisition cost, including installation charges• Estimated residual value upon disposal• Estimated useful life

Depreciation MethodsDepreciation Methods• Straight-Line• Reducing Balance

• Creates a greater charge earlier in the asset’s life, in recognition of its greater (mechanical and economic) efficiency and lower maintenance costs.

• Annual charge: 1 – nth root of (Scrap value / Book value), where n is the number of years remaining

• Consumption• Based on this period’s usage over the estimated total life,

thus allocating costs to the periods in which there is greater wear and tear.

InventoryInventory

• Beginning inventory + Purchases – Ending Inventory = Cost of Goods Sold

• Types of manufacturing inventory:• Finished goods• Work-in-progress• Raw materials and supplies

Inventory ValuationInventory Valuation• Generally, goods in inventory are priced at the lower

of cost and net realizable value. Costs include direct material and direct labor, and expenditures bringing it to its current condition and location.

• Most managers believe that the best valuation method is the one that best matches the sales pricing policy of the company.

• FIFO• LIFO• Average

Not Inventory ValuationNot Inventory Valuation

• Product costs – indirect labor, materials and factory overhead – may or may not be allocated to inventory. Those that are not become part of the current period’s Cost of Goods Sold.

• Period costs – SG&A and financial costs – do not contribute directly to the value of the products and are written off each year.

• There is some latitude in definition, and thus some ability to have these costs allocated to inventory. Selling costs, however, are never such an item.

Interpreting ProfitInterpreting Profit

• As both revenues and costs can be measured in many ways, great care must be taken in interpreting Profit & Loss figures.

• Consistent treatment of depreciation or inventory prevents management from switching between methods solely to influence reported profits.

• 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 that best suits their purpose.

Inflation Adjusted DepreciationInflation Adjusted Depreciation

• This method requires that the depreciation charge be based on the replacement value of the asset (and perhaps its updated residual value).

• It also contemplates that, based on the new replacement value, additional depreciation should have been charged in one or more prior periods:

• The sum of these is ‘top-up depreciation’.

Inflation Adjusted COGSInflation Adjusted COGS

1. Take the simple average of the period’s opening and closing costs.

2. Revise the opening and closing inventory amounts, based on the average cost.

3. Using actual purchases, calculate the new COGS amount.4. The difference between the previous and adjusted COGS

amounts is the COGS adjustment.5. The Profit & Loss has the same opening and closing

inventory values as previously. Q: if we raise the COGS, what is the offset to that expense of not closing inventory?

3. The Balance Sheet3. The Balance Sheet

• The Balance Sheet is often described as a snapshot of a company’s resources on a given date.

• This contrasts with the Profit & Loss Account, which could be described as a video.

Assets, generallyAssets, generally

• Assets could be characterized as:• The untransformed means of production, like

buildings, machinery and raw materials, or• The transformed means of production, like work-in-

progress or finished goods, but not yet released to the Profit and Loss account. Once so released, these costs become expenses.

• The fixed assets are those long-term assets that the company intends to use in the course of its business.

LandLand

• Land has infinite life and does not typically diminish in value. These costs, together with those (capitalized) of putting it in service, are not depreciated.• To reflect its current value, land may be

revalued from time to time. The increased Balance Sheet value is offset with a revaluation reserve in owners’ equity. Profits are unaffected.

LeasesLeases

• Many companies operate fixed assets that they do not legally own.

• A finance lease is one in which the property reverts to the lessee at expiration. Leased assets are shown on the Balance Sheet as fixed assets and the future lease obligations under creditors. Interest is charged to P&L and the capital portion deducted from the reported obligation.

• An operating lease is one in which ownership remains with the lessor. These are not capitalized. The entire lease payment is charged to P&L.

Bad DebtBad Debt

• A time lag between a debt arising (in the accounting period of sale) and the debt being written off (in a succeeding period) breaches the matching convention.

• The Balance Sheet may show a reduced amount for ‘Debtors less provision’. The P&L account is charged with an initial provision for estimated bad debt. In succeeding periods, P&L records only an incremental adjustment.

LiabilitiesLiabilities• If a company has received payment in advance of

providing the service, the cash debit is offset with an Owner’s Equity section credit for deferred revenue.

• The British convention is to group short-term liabilities (expected to be settled in the next period) with short-term assets, and produce a ‘Net current assets’ total for the Balance Sheet. Another such convention is the summing of fixed assets and net current assets to arrive at the Net assets of the enterprise.

Financing Net AssetsFinancing Net Assets

• Assets can be financed with sources that are internally generated:

• From the original equity of the owner, or• From profitable operations, where those profits have

not been distributed (i.e., retained earnings).• External sources are long-term loans, usually

arising from a need to purchase fixed assets or to expand operations. These are often secured.

GearingGearing

• The relationship between owners’ equity and long-term loans is called gearing or leverage:

• Gearing = Long-term debt / Total assets• A highly-geared company will show greater

variance in its returns on equity than one lowly-geared or ungeared. Its returns will be lower in unfavorable markets and greater in more favorable ones.

4. Cash Flow Statement4. Cash Flow Statement

• The Cash Flow Statement provides a reconciliation between profits and cash.

• Profits Cash • Cash equals cash balances, bank balances and

‘cash equivalents’ – investments readily convertible to cash or otherwise maturing into cash within three months.

• An overdraft is merely a negative bank balance.• An overdraft is not a negative current asset, but a

current liability.

Sources of CashSources of Cash

1. Profit from operations

2. Capital introduction3. Increase in creditors4. Sale of assets5. Loans6. Decrease in

inventories7. Decrease in debtors

• Note that depreciation is not a source of cash. It is added back to the profit figure to get cash from operations.

• A gain on the sale of an asset sale is subtracted from profit, and its full price shown as a cash source.

Uses of CashUses of Cash

1. Loss from operations2. Capital repayments3. Decrease in creditors4. Purchase of fixed

assets5. Repayment of loans6. Increase in

inventories7. Increase in debtors

• In general, these are the opposites of the sources, above.

Eight Major CategoriesEight Major Categories

1. Cash flow from operations: working capital accounts for debtors, creditors and inventories are included here.

2. Returns on investments and servicing of finance: including dividends received, interest paid and received, and dividends paid to minority shareholders.

3. Taxation4. Capital investment: Receipts from sales or

expenditures to acquire property, plant and equipment.

Eight Major CategoriesEight Major Categories

5. Acquisitions and mergers: of subsidiaries, associated companies or joint ventures.

6. Equity dividends paid to shareholders.7. Management of liquid resources: the costs

of managing the cash account.8. Financing: receipt and refunding of

shareholders’ funds or debt (except overdrafts).

Deriving the Cash FlowsDeriving the Cash Flows

• Four requirements:• Balance Sheet at the beginning of the period• Balance Sheet at the end of the period• Profit & Loss Statement for the period• The supplementary notes to these financial

statements

5. Financial Reporting5. Financial Reporting

• The law requires a certain amount of financial disclosure from corporations in order to afford a measure of protection to creditors and shareholders.

• The desire to operate with a low level of external interference and to protect sensitive commercial information drives company management to disclose to minimum required.

The DisclosureThe Disclosure

• The Company must publish a Profit & Loss Statement and Balance Sheet that give a fair and true view of, respectively, the profit or loss for the financial year, and the state of affairs as at the end thereof.

• So far as possible, figures must be accurate (or reasonable estimates used), and methods give reasonable assurance that the financial statements are free from deliberate bias, manipulation or concealment of material facts.

Accounting StandardsAccounting Standards

• In Britain, Statements of Standard Accounting Practice (SSAPs) and later Financial Reporting Standards (FRSs) were produced by accounting bodies or boards.

• The jurisdictions’ corporations statutes, current accounting standards and the listing agreements of stock exchanges shape the disclosures; generally accepted accounting principles provide a methodology.

Accounting PoliciesAccounting Policies• Amongst the disclosures is a statement of how

accounting standards were applied to the business (Accounting Policies).

• The company still has some latitude in the selection of its Accounting Policies, so long as:

• The statements give a ‘true and fair view’• The company can obtain the approval of the external auditor• The policies are consistently applied. A change of

circumstances that would prevent an application from producing a true and fair view would justify a new policy. A change and its impact must be documented.

ConsolidationConsolidation• When a company owns more than 50% of other

companies, it must also report its results on a consolidated basis.

• The excess paid for a company’s shares over their book value is called good will, and appears on the holding company’s (unconsolidated) statement as an intangible asset. It reflects a belief that the asset acquired has a greater inherent value.

• The Minority Interest is shown in the consolidation with Owners’ Equity, as a stake in the total net assets of the group.

Exceptional ItemsExceptional Items• An exceptional item is one that is material in

amount but derives from events or transactions that are outside the ordinary activities of the company:

• Profits or losses on the sale or termination of an operation• Costs of restructuring or reorganization designed to have

a material affect on the nature and focus of company operations.

• Profits or losses on the disposal of fixed assets.• This isolates the performance of the core business,

without exceptional items masking the numbers.

Accounting Concepts IAccounting Concepts I

• Going Concern: An assumption that the company will continue to operate for the foreseeable future. A contrary indication must be disclosed, and may result in accelerated write-downs of assets.

• Accruals: Revenues and costs are recognized when the activity is completed, save for settlement.

Accounting Concepts IIAccounting Concepts II

• Consistency• Prudence• Non-Aggregation: In determining the aggregate

amount of any item, the amount of each individual asset or liability that falls to be taken into account shall be determined separately. For example, a company would not be permitted to report Net Current Assets without also calculating Current Assets and Current Liabilities.

The External AuditThe External Audit• An examination of the system of bookkeeping,

accounting and internal control• Comparison of the financial statements with other

company records for consistency• Verification of the title, existence and value of assets• Verification of the amount of liabilities• Verification of the Profit & Loss results• Confirmation that the company has complied with

accounting standards and statutory requirements

Audit ReportAudit Report

• In addition to reporting on whether the company has met statutory and accounting requirements, and that the financial statements provide a true and fair view, the report will indicate if the auditor is unsatisfied that:

• Required information and explanations were obtained• Proper books of account have been kept• Proper returns were received from offices not visited• Accounts are in agreement with the books

AuditorAuditor’’s Opinions Opinion

• Unqualified: nothing was found that would detract from a view that the reports provide a true and fair view.

• Qualified: with specifics as to why the auditor in unsatisfied, and the effects on accounts and amounts.

6. Interpretation of Financial 6. Interpretation of Financial StatementsStatements

• Absolute figures are not helpful by themselves. A ratio reduces the data to a workable form and makes it more meaningful.

• Percentages or ratios permit easy comparison between periods or different corporate entities.

• Ratios may suppress poor absolute figures.• Differences in definition are ultimately less

important than consistent application.• Trends are usually more meaningful than a single

period analysis.

Financial and Ratio AnalysisFinancial and Ratio Analysis

• Four types of ratios• Liquidity: Measure a company’s ability to meet its

maturing short-term obligations• Profitability: Measure management’s overall

effectiveness.• Capital Structure: Examine the asset structure of the

company; analyze the company’s dependence on debt (gearing ratios).

• Efficiency (activity or turnover): Indicate the company’s effectiveness in managing its assets.

Ratios IRatios I

1. Current ratio = Current assets / Current Liabilities

2. Quick Ratio (Acid Test) = (Current Assets – Inventory) / Current Liabilities

3. Profit Margin = Net profit before interest and taxes / Sales

4. Return on Total Assets = Net profit before interest and taxes / Total Assets

5. Return on Owners’ Equity = Net profit before interest and taxes / Owners’ Equity

Ratios IIRatios II

6. Fixed to Current Asset Ratio = Fixed Assets / Current Assets

7. Debt Ratio = Total Debt / Total Assets Creditors look to the owners’ equity to provide a

margin of safety. Companies with low gearing ratios have less risk of

loss in economic downturns, but also have lower returns when the economy performs well.

8. Times Interest Earned = (Profit before tax + Interest Charges) / Interest Charges

Ratios IIIRatios III

9. Inventory Turnover = Sales / Inventory10. Average Collection Period = Debtors /

Sales per day11. Fixed Assets Turnover = Sales / Fixed

Assets

One Hundred Percent StatementOne Hundred Percent Statement

• In relation to profitability and cost control, a favorite technique is the One Hundred Percent Statement.• Sales are set at 100%• Each item of cost is calculated as a percentage

of sales.

Stock Market RatiosStock Market Ratios

• Earnings per Share = Net Profit / # of common shares issued

• Price Earnings Ratio (PE) = Market Price / Earnings per share

• Dividend Yield = (Dividend per share / Market Value per share) x 100. This calculation may be modified by “grossing up” the dividend to account for a tax credit. If the credit were 20%, the dividend should be multiplied by 100/80.

• Dividend Cover = Net Profit / Dividend Payout.

7. Emerging Issues7. Emerging Issues

• There is extraordinary pressure on listed companies to show earnings growth (short-termism). One response is to adopt accounting principles that give the appearance of an upward trend in performance.

• As much Research & Development (R&D) is of uncertain value, companies take the view that it is prudent to write off the expenditure as it is incurred rather than capitalize outlays that may turn out to be worthless.

Capitalizing R&DCapitalizing R&D

• Development costs can be capitalized if:• There is a clearly defined project• Expenditure is separately identifiable• There is reasonable certainty of technical

feasibility and commercial viability• The costs are reasonably expected to be

exceeded by future sales• Adequate resources exist for the project to be

completed

Off-Balance-Sheet TransactionsOff-Balance-Sheet Transactions

• A highly-geared company may be inclined to drive further borrowings off the Balance Sheet in such a way as to avoid disclosure. This is sometimes accomplished with:• Quasi-subsidiaries• Consignment inventories• Sale and repurchase agreements• Debt factoring

Quasi-subsidiariesQuasi-subsidiaries• An investing company can engineer the share capital and

voting rights of another company or a joint venture so as to avoid 50+% ownership but maintain effective control. This company’s debt, then, is not on the investor’s Balance Sheet.

• Under Financial Reporting Standard (FRS) 5, to avoid consolidation:

• The risks and rewards of ownership must be in the company or JV (no beneficial terms)

• Influence and management must be evenly balanced• Profits, losses, dividends and/ or loan guarantees must be shared

equally.

Consignment InventoriesConsignment Inventories

• Sometimes a manufacturer will deliver goods to a dealer on consignment, typically not requiring payment (including financing) until the goods are sold.

• If the dealer is ultimately obliged to pay for the goods, whether or not sold, this risk is an indication that the goods are the dealer’s inventory.

• If the goods can be returned without significant penalty, then the dealer can avoid recording it as inventory, with the attendant obligation .

Sale and Repurchase AgreementsSale and Repurchase Agreements

• Goods are sold for cash, with part of the consideration being the subsequent repurchase of the goods, at a price that embeds a finance charge.

• FRS 5 would examine the substance of the transaction. Is it:

• An arm’s length sale (did the risk and benefit of ownership pass?)

• A financing deal with the goods held as security?

Debt FactoringDebt Factoring• Accounts receivable can be ‘sold’ at a discount to their face

value to a finance house, who then attempts to collect the full value.

• The critical question is whether the finance house has any recourse to the vendor if the debts are not recoverable.

• If so, FRS 5 requires the vendor to recognize the potential liability.

• The A/R might remain on the Balance Sheet and the cash received matched with a short-term loan from the finance house. If there is no subsequent liability, the A/R and loan are eliminated, with the loss from factoring then transferred to P&L.

Acquisition and Merger IAcquisition and Merger I• Under UK law, amounts paid for shares (including

any premium) cannot form part of a dividend.• If a company ‘acquires’ another for shares:

• Any premium paid over Net Assets is shown as good will.• Any distributable reserves of the acquired company lose

this quality • A ‘merger’ presumes instead that the parties have

agreed to pool their interests:• There is no good will or share premium• The distributable reserves are pooled

Acquisition and Merger IIAcquisition and Merger II• Merger accounting is required when:

• Neither party sees itself as ‘acquiring’ or ‘acquired’• Neither party dominates the management of the combined

entity• A party does not dominate the combination due to relative

size• Each party receives primarily equity shares• No shareholders retain a material interest in only part of the

combined entity• In general, it will be difficult to meet all these criteria

to qualify for merger accounting.

Good Will I Good Will I

• Acquisition accounting requires that the assets of the acquired company be recorded at fair value rather than historical cost

• This decreases the amount of good will when there is significant disparity between the cost bases.

• This also returns good will to its essence: something ‘extra’ for the value locked up in the acquired company.

• If good will is written off in the current period, this may suggest that the net worth of the combination is declining when the opposite is probably true.

Good Will IIGood Will II

• The combined entity can capitalize the asset, but it is difficult to determine the amounts to write off as it diminishes in value.

• Professional opinion favors the lesser of useful economic life or 20 years, unless there is compelling evidence otherwise.

• The speed of write-off need not be constant, and its estimated useful economic life should be periodically reviewed by management.

Brands IBrands I

• Brands are the names of consumer products that, if well-known, could be seen as having value to the companies that own them.

• This increases the size of the assets on the Balance Sheet – with implications for gearing or mere size – but also reduces return on assets.

• A purchased brand would seem to stand on different ground, assuming that its cost (in a larger transaction) could be isolated.

Brands IIBrands II

• For home-grown brands, the value might be based on:• Historic costs of developing and maintaining

the brand, resurrected from prior periods’ expenses to become an intangible asset (WorldCom!).

• An estimate of its power to increase earnings, with an appropriate multiplier based on its durability.

Operating & Financial ReviewOperating & Financial Review

• The OFR is optional in the UK, and appears to have the same purpose as the Management Discussion portion of SEC filings.

• International harmonization of accounting standards is inevitable in a global economy. The International Accounting Standards Committee is sponsored by 50 countries, and may have some role in the transition to an international standard.

8. Intro to Management 8. Intro to Management AccountingAccounting

• The accounting information contained in a set of corporate financial accounts is historic: reflecting trading activities and the resources on hand at the beginning and end of the period.

• The forward-looking branch of the discipline is called management accounting. It is not an objective, well-defined discipline, nor must it take account of the different informational needs.

Managerial ResponsibilityManagerial Responsibility

• A manager wishes to ensure that things get done efficiently and on time. These are usually determined by comparison to the company’s plans, which he made have had a hand in developing.

• The sum of the managers’ plans must be a realistic and practical proposition.

Planning and Control LoopPlanning and Control Loop

• Planning• Broad objective of the function or company• Alternatives to achieving objectives• Work out costs and revenues of alternatives• Select the favored alternative and commence

operations• Control

• Track actual performance against the plan• Take remedial steps to solve problems.

Feedback

Mgmt accounting informationMgmt accounting information• No formal structure• No externally imposed rules• Not compulsory (although certainly necessary)• Not just money terms: may consider labor hours,

materials used, energy consumed• Tends to be forward looking, and therefore with less

emphasis on precision• May consider business segments rather than the whole• No formal audit, although the auditors will be

interested in its control aspects

Costs relevant to mgmt decisionsCosts relevant to mgmt decisions

• Direct material is material that is easily identified in the finished product, in contrast to supplies, which are consumed in the process but less traceable (glue, screws).

• Direct labor (measured in time and price) is directly traceable to the product, contrasted with supervision and head office.

• Prime cost = Direct Material + Direct labor

9. Cost Characteristics9. Cost Characteristics

• Cost in one of the most fundamental control mechanisms in a management information system. With a knowledge of cost, managers can:

• Control actual performance against planned performance

• Plan next year’s costs• Determine a desirable selling price• Track the consumption of the organization’s resources• Choose among alternative courses of action

Variable and Fixed CostsVariable and Fixed Costs

• Variable costs vary directly with the level of production; fixed costs are unaffected by the level of production.

• Depreciation is treated as a fixed cost:• Although we would expect machinery to

depreciate with usage, the most prominent criterion in the depreciation of value is the passage of time, which brings with it technological obsolescence.

Beware the Unitizing of Fixed Costs!Beware the Unitizing of Fixed Costs!

• The allocation of fixed costs per unit vary with the production level.

• By dropping a product line, for example, the fixed costs previously borne by that product now have to be allocated amongst those remaining.

Direct and Indirect CostsDirect and Indirect Costs• Costs that are incurred simply because an item is

produced are direct costs; all others are indirect costs.• The indirect costs are incurred in support of

production, rather than being production themselves.• A less-used categorization is traceable and common

costs.• Traceable costs are, by definition, those costs that can be

traced into the cost item.• Common costs are those incurred by a business to support

all production.

Product and Period CostsProduct and Period Costs

• The significance of this cost category is in valuing inventory for financial reporting purposes.

• Product costs (raw materials, direct labor, depreciation, factory overhead) are allocated at period end to either COGS or inventory.

• Period costs (selling, administration, financial) are written off to the Profit & Loss account without any prior allocation.

Controllable/ Non-Controllable CostControllable/ Non-Controllable Cost

• The term ‘controllable’ refers to the person who can be held accountable for the costs being measured.

• The concept of control is also influenced by the time scale.• A shift supervisor cannot be accountable for the

loss of machinery during a shift, but is accountable for the maintenance budget over a year.

Standard and Actual CostsStandard and Actual Costs

• By means of an engineering study and through experience, a company will set standard costs:• These are the budgeted costs for one cost item,

both variable and a share of fixed.• Against this benchmark, actual costs are

measured period by period. Management would seek explanation for significant variances.

Engineered and Discretionary CostsEngineered and Discretionary Costs

• A business cannot avoid the costs that are engineered into the product.

• They do, however, have a discretion around items such as Research & Development, or the levels of administrative support or machine maintenance.

Break-Even ChartBreak-Even Chart

• The sales revenue line climbs from zero (no sales: no revenue) at the rate of revenue earned per unit sold. Its point of intersection with the total cost curve is the break-even point.

• The difference between the break-even point and the actual level of sales, if greater than break-even, is called the margin of safety.

Calculating Break-Even PointsCalculating Break-Even Points• The Profit/ Volume Ratio measures the contribution

to fixed costs per unit:• P/V ratio = Contribution / Sales Price

• Equation Method: Break-even Sales Amount = Fixed Costs + Variable Cost (expressing the latter term as a proportion of sales)

• Contribution Margin Method (gives units): BEP = Fixed Costs / Contribution margin

• Contribution Margin Ratio Method (gives value): BEP = Fixed Costs / Contribution Margin Ratio

Limiting Factors of ProductionLimiting Factors of Production

• A limiting factor is the ultimate bottleneck that limits production quantities: space, machine hours or skilled labor.

• Optimization depends on obtaining the maximum contribution per unit of limiting factor.

10. Allocating Costs10. Allocating Costs

• Businesses develop costing systems that are unique to them and that attempt to reflect their particular (and changing) production characteristics.

• Materials are perhaps the easiest cost to trace to a cost item because of their visible, physical nature.

• Rather than using an inventory system (LIFO, FIFO, average) based on actual costs, it is more likely that a standard price would be used. Any variance between this estimate and actual would be accounted for in the Profit & Loss at the end of the period.

Labor CostsLabor Costs

• Labor cost is a multiple of time spent on the job and rate of pay earned by the operatives involved.• Due to differing rates of pay, the calculation

uses a standard wage rate, as for materials.• The rate goes beyond wages to include benefits

and employer-paid payroll taxes.

Overheads IOverheads I

• Manufacturing and non-manufacturing overheads are indirect costs.

• Before spreading the overheads to units of production, these costs must first be gathered into cost centers, for which individual managers will be responsible.

• A predetermined overhead rate will allocate overheads across units of production:

• Allocation Rate = Budgeted overhead / Budgeted production units

Overheads IIOverheads II

• Cost accountants search for causal factors or activity bases – the one particular factor related to most of the heads of cost that comprise overhead. Typical activity bases are direct labor hours, direct labor cost or machine-hours.

• Estimated overhead is divided by the estimated quantity of the causal factor. The resulting predetermined rate is applied to the individual products using these products’ consumption of the causal factor.

• Variances are accounted directly to Profit & Loss.

Overheads IIIOverheads III• Departmental overhead rates attempt to avoid the

problem of the differing activity bases, first, by allocating overheads to individual departments, and second, by identifying the activity base most appropriate for each department.

• Since products flow through production departments and not service departments, the first step in the allocation process must be to transfer service department overheads to the production departments so that they can be ‘attached’ to the products as they go through.

Direct and Step AllocationDirect and Step Allocation

• The direct method empties overheads from the service departments into the production departments. Each service department is taken in turn using a suitable activity base.

• No accounting for inter-departmental service.• The step method recognizes this interdependency.

The sequence may based on:• Descending order of magnitude of overhead spend• Descending percentage of service to other departments

• The activity base does not consider services provided to itself or to ‘emptied’ departments

Joint ProductsJoint Products

• The true characteristic of a joint product is that it must appear during the processes involved in producing the main product.

• If the product need not emerge from the process, the products cannot be deemed to be joint.

• Allocation possibilities:• Equal shares• Physical characteristics: weight, volume or difficulty in

handling cause certain costs to be incurred. • Sales value at split-off• Ultimate sales value: deducts post-split-off processing

costs, and allocates on the net amount.

Why Allocate These Costs?Why Allocate These Costs?

• For product management: understanding the resources being consumed by the product

• Inventory valuation• Price-setting under cost-plus pricing

By-ProductsBy-Products• A by-product is one that emerges from a production

process that is designed to produce another product.• This usually has low commercial value compared to the

main product.• No attempt is made to allocate costs between the

products.• Revenues from the by-product are deducted from the

processing costs.• Unsold by-products are carried in inventory at zero cost,

and allow no deduction from processing cost.

Process CostingProcess Costing

• Job costing is characterized by separate products that incur separate costs.

• Process costing is applied in industries where no uniqueness is identifiable in the products produced and where the process is almost continuous.

• An equivalent unit of production is an assessment of the degree of completion of a unit under each major component of cost.

Cost per Equivalent UnitCost per Equivalent Unit

• The costs to be accounted for by a production activity in any accounting period comprise two parts:

• Those attaching to the opening work-in-process at the beginning of the period but were incurred in the previous period

• Those incurred during this accounting period in order to finish the opening work-in-process, make units started and completed in the period, and start work on the units left in the closing work-in-process.

• Only the costs of the current period are used to calculate the cost per equivalent unit of production.

Activity-Based Costing (ABC)Activity-Based Costing (ABC)

• Activity-Based Costing is based on a belief that activities (e.g., production planning, quality inspection), rather than products, cause costs to be incurred. The products consume activities, and thereby costs.

• Different activities have different cost drivers.• ABC permits products to be loaded up with those costs

they incur. • Product diversity causes problems for traditional

costing systems. Products with low resource consumption may bear a more than their share of costs and vice versa, thus creating cross-subsidies.

11. Costs for Decision-Making11. Costs for Decision-Making

• Absorption costing:• Based on the planned production volume, absorption

costing allocates a share of the fixed production cost to each production item.

• This cost does not change if production volumes are greater than or less than forecast. Instead, an adjustment is made to a P&L line item “Denominator volume variance” to represent the over-collection or under-collection of fixed costs.

• When production does not equal sales, the incremental cost component is sent to or drawn from inventory cost.

Variable CostingVariable Costing

• Variable costing is the more traditional method:• The pool of fixed costs is deducted as COGS

from current period sales, regardless of additions to or draws from inventory.

• Inventory volume carries its variable costs only.

Absorption v. VariableAbsorption v. Variable

• The main difference is in the timing of fixed production expenses:

• Variable recognizes them all in every accounting period.

• Absorption, through inventory valuation, allows some portion of fixed costs to be drawn from a previous period or sent to a subsequent period.

• Profit:• Under variable, is a function of sales.• Under absorption, profit is influenced by sales and by

production levels.

An Analytical FrameworkAn Analytical Framework

• Task One: Define the problem and list all feasible alternatives.

• Task Two: Cost the alternatives.• The relevant costs are those that differ for the alternatives under

review. It may be useful to list just the cost differences rather than the full cost of each.

• Task Three: Assess the qualitative factors.• Task Four: Make the Decision.

• To do nothing is a valid decision.• A decision can be put off in order to gather more

information, if the benefits of doing so would outweigh the costs.

Costing Alternatives ICosting Alternatives I

• Relevant costs are:• Future costs: Old costs (i.e., sunk costs) cannot be

influenced by future decisions• Cash costs: must involve cash flows and not

accounting devices such as depreciation or write-offs• Avoidable costs: an unavoidable cost will be incurred

whatever option is selected. • Differential costs: the reallocation of a resource within

the company is relevant only if the company’s overall financial position is affected.

Costing Alternatives IICosting Alternatives II

• Opportunity costs: Just as there may be certain costs and benefits attendant upon choosing one alternative, there may also be relevant revenues or benefits foregone by not choosing the other.

• In interpreting full cost information:• A variable cost should vary but it can be seen to remain

fixed per unit• A fixed cost should remain fixed, but when converted

into a fixed price per unit, the cost appears to vary (beware the unitizing effect!)

• In a shut down decision, certain variable costs may be unavoidable (thus acting like fixed).

Costing Alternatives IIICosting Alternatives III

• Management should not confuse the costs required for long-term pricing strategies with those required to deliberate on special orders.

• No technique for allocating joint product costs is applicable to management decisions of whether a product should be sold at the split off point or processed further.

• Such decisions can be aided only by incremental or relevant cost analysis.

12. Budgeting12. Budgeting• Budgeting is the predictive step in the management

process. It has the following attributes:• Co-ordination of activities• Planning: Without some idea of where the organization is

heading, it is impossible to anticipate resource requirements or gauge performance.

• Motivation: the provision of individual and collective targets

• Control: measurement against those targets• The budget is only a numerical expression of the plan

– it is not the plan itself.

Budgeting Obstacles IBudgeting Obstacles I

• Time Taken• A good budget process is an iterative one, thus requiring

sufficient time for discussion and feedback.• There can be no firmer basis for next year than what

happens this year. Therefore, the budget process should start as late as possible in the current year consistent with getting agreement by the start of the new year.

• Lack of Top Management Commitment• Only if the whole management team shares the ideal of

constant improvement in operating performance will the commitment of lower-level staff be ensured.

Budgeting Obstacles IIBudgeting Obstacles II

• Top-down Control• Perceptions that the process is intended to minimize

resources or is devised without consultation is unlikely to have the support of the management level charged with implementation.

• Blurred responsibilities• It is unfair and de-motivating to lower-level budget

holders to assess their performance on managing costs over which they have no control.

Budgeting Obstacles IIIBudgeting Obstacles III

• Moving goalposts• A change in circumstances can invalidate the premises

of the budget projections. Rolling twelve-month budgeting or adherence to the original budget are usually favored over budget amendment. The portion over which management has control can be isolated.

• Rewarding Inefficiency• Management must adopt a more rigorous and analytical

approach to uplifts or cuts in budgets than blanket percentages.

Zero-Based BudgetingZero-Based Budgeting• ZBB bundles discretionary costs – e.g., R&D, machine

maintenance and legal services – into discrete packages, starting with the most fundamental and receding in priority.

• These activities bid for resources as if they were new projects, i.e., from a zero base.

• ZBB forces management to relate the budget expectations of experts with the strategic direction of the company.

• It is difficult to break homogeneous activities into such packages, and the budget owner is motivated to size them to maintain the status quo.

13. Standard Costing13. Standard Costing

• 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.

• We use standard costs for this control process.• Standard costs are budgeted costs for individual

cost items.

Setting StandardsSetting Standards

• An engineering study might consider the amount of material required, complexity of the design, material form and quality, skill of labor required and the precision of the machinery used. This results in an engineering or ideal standard.

• Since the engineering standard is not going to be consistently attainable, we consider the normal perils of the process to arrive at a normal or operating standard.

MotivationMotivation

• One can neither manage nor work to an unattainable standard.

• A properly designed standard will motivate employees to strive to meet the standard and reward them for so doing.

• The standard may have to be periodically revisited to ensure that it still provides a stretch target.

Flexible budgetsFlexible budgets

• Budget numbers are flexed to the level of output actually achieved, so that management can compare the costs incurred with those that would have been established for that level of output.

Variance, generallyVariance, generally• Standard cost = direct materials + direct labor + variable

overhead• An adverse variance is one where actual cost is above

standard cost; a favorable variance is one where actual cost is less than standard cost.

• Exception reporting allows management to focus on those aspects of the operation that are outside of a defined tolerance. Difference should be sufficient to justify the cost of investigation and management action.

• Investigation may be hampered by interdependencies.

Variances, materials Variances, materials

• Material efficiency variance: [std quantity used – actual quantity] x std price per unit

• Material price variance: [std unit price – actual unit price] x actual quantity used (or purchased)

• Process may consume less of a higher quality (and usually higher price) material; or more of a lower quality (and usually lower price) material. This can also directly affect the amounts of labor or variable overheads required.

Variances, laborVariances, labor

• Labor efficiency variance: [std time allowed – actual time taken] x std rate

• Labor rate variance: [std rate per hour – actual rate] x actual time taken

• Labor may be more or less skilled; aided or hampered by materials, equipment; become more expensive with overtime/ downtime

Variances, variable overheadVariances, variable overhead

• Efficiency variance = [std cost of flexible budget time for units produced] – [std cost of actual time taken for units produced]

• Spending variance = [std cost of actual time taken for units produced] – actual costs incurred

Variances, fixed overheadVariances, fixed overhead

• Spending variance = Budgeted amount – Actual amount

• Denominator variance = Budgeted amount – Amount applied to units produced

Variances, salesVariances, sales• Sales contribution variance = (individual margin

x units sold)• Sales volume variance = (individual sales volume

@ budgeted margin)• Sales quantity variance = total volume x average

margin• Sales mix variance = (individual sales volume x

(budgeted margin – average margin)• Check: Sales volume variance = Sales quantity

variance – Sales mix variance

14. Accounting for Divisions14. Accounting for Divisions

• Whether it grows organically or by acquisition, the size of a corporation may prevent the management team from exercising sufficient scrutiny of day-to-day operations.

Advantages and DisadvantagesAdvantages and Disadvantages

• Advantages:• Specialization• Local knowledge can be

brought to bear immediately on local problems.

• Motivation: running their own shop

• Speed of implementation• Career mobility: training

ground for managerial talent

• Disadvantages:• Diminished control• Duplicated costs• Internal rivalries• Local versus corporate

interest

Types of DivisionsTypes of Divisions• Cost center: responsible for managing costs but

not associated revenues• Revenue Center: responsible for generating

revenues without reference to underlying costs• Profit Center: performance is assessed based on

the bottom line• Investment Center: Net assets are taken into

account, to assess efficiency as well as profitability

Controllable Revenues and CostsControllable Revenues and Costs

• The profit and loss account can be restructured to show the only those costs and profits that are within the control of the division.

• Any portion of the division’s share of head office costs that does not benefit the division is excluded.

Asset Base ValuationAsset Base Valuation

• Replacement Cost: reference to market prices for similar assets. When there is a market, this values assets fairly.

• Net Book Value: The difference between the purchase price and accumulated depreciation, whether or not this approximates true value. Despite its shortcomings, this is the preferred metric.

Assessing PerformanceAssessing Performance• Return on investment: the ratio of profit to net book value

of fixed assets, expressed as a percentage. A division’s net book value (asset base), in the absence of replacement, is falling year by year. A steady profit, in such a situation, is producing increasingly larger returns on investment (ROI).

• Residual income: a division is charged interest on its assets at the company’s cost of capital (therefore, there is no depreciation). Any opportunity yielding a positive RI should be accepted.

• Top management must distinguish between divisional performance and managerial performance.

Imputed Interest RateImputed Interest Rate

• Low rates favor divisions with high investment in net assets. When the rates are higher, there is a higher imputed interest charge on the assets.

Transfer PricingTransfer Pricing

• Where a market price is available, this is by far the best method.

• Cost-based: but are these variable costs alone or include the absorption rate for fixed costs? What if the production capacity would be otherwise idle?

• Negotiated costs: a euphemism for management imposition. The Company may temporarily book the difference to a reserve, but not rely on such a price distortion in the longer term.

International DivisionsInternational Divisions

• Transfer pricing can be geared to produce the profit in the lower-tax jurisdiction.

• Whether this simple tactic will be used may also depend on the repatriation of profits from the transferring country.

15. Investment Decisions15. Investment Decisions• An investment decision is one whose impact

extends beyond the immediate operating period.• A decision that has its impact within the operating

period is an operating decision.• Restrictions on capital spend will be imposed by the

market or by the Board.• Investment decisions always require forecasts –

explicit or implicit – and future profits are directly related to the success or otherwise of investment decisions.

Investment ProcessInvestment Process

1. Search: All managers have a responsibility to search for worthwhile investments.

2. Evaluation: according to the corporation’s chosen metrics.

3. Control: Once an investment has been undertaken, the financial control of it will follow the normal budgetary control procedures.

Present ValuePresent Value• Present value is based on the ability to earn

interest or the need to pay interest on investments.• This is a separate consideration than the effects of

inflation/ deflation or the risk of loss (which should be evaluated as any other variable).

• PV is the value today of a sum receivable sometime in the future at a given rate of interest. It is given by dividing the receivable by (1 + i)n, where i is the interest rate and n is the number of times the amount is compounded.

Net Present ValueNet Present Value• Net Present Value takes all of the cash flows

associated with a project and reduces (discounts) them to a common denominator (present value) by using an appropriate interest rate (usually the cost of capital or the cost of finance).

• Cash outflows are often described as negative cash flows, and cash inflows as positive cash flows.

• NPV shows whether a project is profitable and whether the rate of return is above or below the imputed cost of capital.

Internal Rate of ReturnInternal Rate of Return• IRR is also known as the discounted cash flow rate of

return.• Instead of discounting by the cost of capital, IRR finds

the interest rate that reduces all of the associated cash flows to an NPV of zero.

• This is usually calculated by an interpolation of two rates providing a positive and negative NPV.

• While IRR does provide a relative measure of profitability, it does not readily lend itself to comparison with an income/ expenditure stream with different cash flows.

Appraisal in Non-Revenue SituationsAppraisal in Non-Revenue Situations

• Cash flows are discounted to NPV in the usual way. The project with the lower NPV is the cheaper.

Risk and UncertaintyRisk and Uncertainty• The important variables in an investment

appraisal are:1. Capital expenditure: the amounts and timing of fixed

and working capital required. One of the common reasons for profitability to fall short of estimates is the time required to complete capital works and become operational.

2. Operating income and expenditure, including taxation.3. Investment life: a race amongst physical deterioration,

market demand and obsolescence. 4. Cost of capital: actual, deemed or average.

Payback PeriodPayback Period

• Payback is the time taken for positive cash flows to recoup the original investment.

• It ignores one of the most important factors in investment: profit. It also treats all cash flows the same, regardless of timing. The latter could be corrected by discounting the cash flows or by adding an interest charge to the amounts carried forward.

• Payback also lacks a ready market comparison.

Sensitivity AnalysisSensitivity Analysis

• Sensitivity analysis consists of changing the value – quantity or price – of a key variable to assess its impact on the final result.

• It is normally assumed that management is aware of the likely critical or key factors and will concentrate attention on these.

• Sensitivity analysis does not build into the evaluation the likelihood of variation from the estimate (expected value).

Risk AnalysisRisk Analysis• We can incorporate sophisticated techniques of

probability analysis, but they cannot create objectivity out of subjective judgments.

• The risk can be regarded as the spread or range around an estimated value. The greater the spread, the greater the risk.

• A high-hurdle test subjects a project to a more rigorous test of acceptability. This forces the investor to an examination of the factors that make investments more or less risky.

Cost of CapitalCost of Capital

• A company may weight the costs of capital, including the cost of service, in its optimum proportions. A loan, since tax deductible, has a net cost calculated by multiplying by (1 – tax rate).

• Opportunity cost: the return achieved must be at least as good as that achieved by investing outside of the organization.

Post-Assessment of Capital ProjectsPost-Assessment of Capital Projects

• This is a series of interim audits in which all the key investment factors are reviewed against the forecast, and an assessment made of the effect of deviations on the profitability of the project and the company.

• This may be a useful tool in the evaluation of future prospects.

• There is the implication of a real option before completion: abandonment.

16. Developments in Mgmt Acct16. Developments in Mgmt Acct

• In a high-technology environment, competition on price is intense and the demand for a management accounting system to identify accurate product costs becomes more pressing.

• The marketing edge is often derived from having critical information about customers – their requirements, their problems, and their own plans for development.

Target CostingTarget Costing• Target costing has been developed to help

companies manage their costs in circumstances where the selling price is known.

• The desired margin is deducted from the target price to determine the target cost beyond which the company would consider it uneconomic to produce and sell the product.

• Value engineering involves a complete reappraisal of every aspect of the manufacture and distribution.

Target Costing, 2Target Costing, 2

• There is often an emphasis on design: to have fewer components, or less material, or to require less labor or machine time.

• It is only once the model or process has gone into (stable) production would it be possible to establish the standard costs against which actual costs would be controlled.

Life Cycle CostingLife Cycle Costing

• Life cycle costing gathers all revenues and costs associated with a product or service over its whole lifespan (prototype design to withdrawal of maintenance) so that its ultimate profitability can be measured and management decisions taken thereon.

• Does not differentiate between capital and revenue expenditure (i.e., limits the constraints of annual accounting dates).

Throughput AccountingThroughput Accounting• This is a concept intended to optimize sales when

there is a constraint (“bottleneck”) in inputs or production facilities.

• A business can only earn profits if the rate at which it earns money from sales is greater than the rate at which it spends money on production.

• Depreciation and other fixed costs are considered “sunk”.

• There is value in finished inventory only if it can be readily sold.

Throughput Accounting FormulaeThroughput Accounting Formulae

• Return per factory hour = (Sales price – Material cost) / (Time spent at the bottleneck per product)

• Cost per factory hour = (Manufacturing overhead + direct labor cost) / Total time available at bottleneck

• Throughput accounting ratio = Return per factory hour / Cost per factory hour

• A ratio of less than one indicates that the product is losing money.

Costing for Competitive AdvantageCosting for Competitive Advantage

• Strategy: a course of action, including a specification of resources required, to achieve a specific objective.

• A production strategy might be:• A productivity percentage increase to be achieved in the

next budget period• To build production capacity for a new product line• To improve the quality of finished goods to an acceptable

level of rejects• To buy components rather than make them, or vice versa