SESSION 4: BUDGETING & FINANCE

Objectives of this seminar: To introduce the concept of Accounts and Bookkeeping Main accounting concepts including double-entry, depreciation, accruals and prepayments Accounting Financial statements: Profit and Loss Account, Balance Sheet and Cash Flow Statement Budgets and Control Analysis of Accounts Introduction to Cost Centre Concept

The Accounting Concept

Accounting is the language used by businesses to determine not only how their business is performing, but more importantly, to identify whether the business is profitable or not. The Accounting Concept is attributed to the works of a 15th century monk who studied and developed the concept of bookkeeping as the means of keeping organizational records. Accounting subsequently developed from bookkeeping as the method of maintaining records for profit-oriented organizations.

The Accounting Equation

The Accounting equation is composed of the following items: Capital, which is defined as being all those items, and not only money, which are introduced into an organization by the owner(s) of the business. Assets, which are all those items which belong to the business, or else are due to the business. Liabilities, which are all those items which are borrowed by the business, or else are due to someone else. The Accounting Equation is the following: ASSETS = CAPITAL + LIABILITIES

Example of the Accounting Equation

When a supermarket is opened, the owner introduces Lm10,000 cash, Lm25,000 worth of Furniture and Lm15,000 worth of groceries. At this point, the total Assets of the supermarket amount to Lm50,000. The Accounting Equation is therefore: ASSETS = CAPITAL + LIABILITIES Lm50,000 = Lm50,000 + Lm0 Following the first day of operations, the owner sells Lm2,000 worth of groceries for cash and reorders another Lm5,000 worth of groceries from suppliers. The Accounting Equation has now changed to the following: ASSETS = CAPITAL + LIABILITIES Lm55,000 = Lm50,000 + Lm5,000

Classification of Items in Accounting - I

Accounting is composed of the following different groups or items: Fixed Assets, which refer to those assets which are purchased by the business or introduced into the business by the owner(s), which will be retained within the business for a considerably long period of time, normally more than one year.Examples are Land and Buildings, Machinery, Motor Vehicles and Furniture. Current Assets, which refer to those assets which are purchased by the business or introduced into the business by the owner(s), which will be resold or disposed of within a short period of time, which is normally less than one year. Examples are Stock, Debtors, Prepaid Expenses, Cash at Bank and Cash in Hand. Long-Term Liabilities, which refer to those liabilities which will be repaid after a considerably long period of time, which is normally more than one year. Examples are Bank Loans, Loans from individual businesses and any long-term creditors

Classification of Items in Accounting - II

Current Liabilities, which refer to those liabilities which will be repaid within a short period of time, normally within one year. Examples are Expenses Owing, Creditors, Dividends Payable and Revenues Prepaid. Revenues, which refer to all those earnings that the business earns during a financial year. Revenues are accounted for when they are earned, and not when the actual money is received. Examples are Sales, Rent Receivable, Interest Receivable and Commission Receivable. Expenses, which refer to all those payments made by the business in its daily operations. Similar to revenues, expenses are accounted for when they are incurred, and not when the actual money is paid. Examples are Wages & Salaries, Rent, Water & Electricity, Stationery, Motor Vehicles Expenses and Depreciation.

Double-Entry Records
Accounting is based on the Double-Entry System, which necessitates that for every debit entry made in one account, a simultaneous credit entry must be made in another account. For example, a payment of rent by cash of Lm40 will result in an increase in the rent paid for the year of Lm40, but a decrease in the amount of cash held by the business of Lm40. The Double-Entry System for Assets, Liabilities, Capital, Revenues and Expenses is the following:In the case of Assets and Expenses, an increase in the account is illustrated by debiting the account, whilst a decrease is accounted for by crediting the account. In the case of Liabilities, Capital and Revenues, an increase in the account is illustrated by crediting the account, whilst a decrease is accounted for by debiting the account.

Books of Accounts
The main books of accounts are the following:The General Ledger, in which all accounts with the exception of debtors and creditors, cash and bank accounts. The Sales Ledger, in which are kept the accounts of all debtors. The Purchases Ledger, in which are kept the accounts of all creditors. Apart from these main books, a business also keeps the following books of prime entry:The Cash Book, in which are kept the Cash and Bank accounts. The Sales Journal, in which are recorded all credit sales. The Purchases Journal, in which are recorded all purchases made on credit. The Returns Inwards Journal, in which are recorded all returns inwards from debtors. The Returns Outwards Journal, in which are recorded all returns outwards to creditors. The Journal, which is kept to record all corrections to errors made in the accounts.

Main Accounting Statements

The main accounting statements that are kept by businesses are:The Trial Balance, in which all outstanding debit and credit balances are matched and the totals of which must agree. If these totals do not agree, then there are some errors in the accounts. The Profit and Loss Account, from which a business determines whether it would have made a profit or loss for a particular period of time, normally one year. The Balance Sheet, which illustrates the financial position of a business at a particular point in time. This statement is a translation of the Accounting Equation, as the two totals of the balance sheet showing the assets, liabilities and capital must agree. If these two balances do not agree, then a mistake has been made in drawing up the Profit and Loss Account and the Balance Sheet. The Cash Flow Statement, which is a statement illustrating the financial liquidity of a business. In this statement are illustrated the main cash inflows, which are subsequently matched against the main cash outflows to determine the cash position as at a particular date. Similar to the Balance Sheet, this is a statement of the business position at a particular point in time.

Example of a Trial Balance

The Trial Balance is made up of two columns - one for the debit account balances and the other for the credit account balances. A typical Trial Balance is the following:
e ta ils Land and Buildings Motor Vehicles Capital Stock Cash at Bank Creditors Debtors Rent Commission Receivable Water & Electricity Wages & Salaries Motor Expenses Rent Receivable Furniture Loan from Bank of Valletta Interest on loan Cash in Hand Depreciation on Motor Vehicles Depreciation on Furniture Bad Debts Stationery Computers e b it ( m ) 25,000 16,000 2,500 8,500 50,000 68,000 3,000 8,500 5,000 80,000 6,500 15,200 14,000 150,000 4,000 150 5,000 3,500 5,200 6,350 19,000 271,700 r e d it ( m )

48,000

271,700

Example of a Profit & Loss Account

The Profit and Loss Account involves the matching of all revenues earned by the company against all expenses incurred by the company during a particular period. A typical Profit and Loss Account is the following:
w ift
T ra d ing a nd P ro fit a nd L o ss A c c o unt fo r the y e a r e nd e d 31st e c e m b e r 1996

Opening Stock add Purchases less Closing Stock Cost of Goods Sold Gross Profit c/d

Lm 300 Sales 4,260 4,560 (550) 4,010 2,690 6,700 520 Gross Profit b/d 190 240 70 110 1,560 2,690

Lm 6,700

6,700 2,690

Wages Lighting and Heating Rent General Expenses Carriage Outwards Net Profit

2,690

Example of a Balance Sheet

The Balance Sheet illustrates a companys financial position at a particular point in time, similar to a photograph of the organizations financial health. A typical Balance Sheet is the following:

B Bryant Balance Sheet as at 31st December 1999 Lm Fixed Assets Capital Buildings 2,000 Balance at 1st January 1999 Fixtures and Fittings 750 add Net Profit for the year 2,750 less Drawings Current Assets Stock 550 Debtors 1,200 Long-Term Liability Bank 120 Loan from J Marsh Cash 40 Current Liabilities Creditors 4,660

Lm 2,100 1,560 3,660 (900) 2,760

1,000

900 4,660

Example of a Cash Flow Statement

The Cash Flow Statement enables management determine the financial health of an organization. A typical Cash Flow Statement is the following:
R Lester Cash Flow Statement for the year ended 31st December 1999 Lm Lm Source of Funds t 11, Net Depreciation 2, 10 450 Cash rom sale of Fixed Assets 380 Increase in ad debts provision Decrease in tock 2,320 Increase in creditors 1,590 Sale of Fixed Assets 900 New Capital Introduced 600 8,850 Funds Generated from Operations 19,920 less outsource of funds Increase in Debtors Loan repaid to J orsey Drawings Funds Applied in the Business Decrease in Cash Funds Represented by: Cash and Bank Balances at 1st January 1999 Cash and Bank Balances at 31st December 1999

(5, 20) (6,000) (8,560) (20,280) (360)

4,060 3, 00 (360)

Question One:
XYZ Ltd presents the following balance sheet as at 30th June 2000:
F ixe d A s s e ts S to c k s D e b to rs C ash 4 ,0 0 0 T ra d e C re d ito rs 2 ,5 0 0 A c c rue d T a xa tio n 1 ,3 0 0 5 ,0 0 0 C a p ita l 1 2 ,8 0 0 3 ,5 0 0 1 ,5 0 0 7 ,8 0 0 1 2 ,8 0 0

During the month of July 2000, the company bought Lm50,000 worth of goods. It paid for Lm47,500 of this and also for the Lm3,500 owed at the beginning of July. Not all the goods were sold and the value of goods in stock at the end of July was Lm6,500. The company also paid out Lm80,800 in other expenses, and paid the tax due. There was tax owing of Lm2,500 at the end of July. In addition, a van was bought for Lm12,000, and the total depreciation charge for the month worked out at Lm3,200. Sales during July were Lm140,000, most of which was paid for with cash, except for one invoice for Lm6,000 which was unpaid at the end of July. The Debtors of Lm1,300 all paid up what they owed. Finally, it was decided that a dividend of Lm3,000 would be paid at the end of August 2000. You are to draw up the Profit and Loss Account, Balance Sheet and Cash Flow Statement for the month of July 2000

The Main Accounting Concepts I

The Going Concern Concept For the Final Accounts to be accurate, it is assumed that an organization will continue in existence for the foreseeable future, unless there is strong evidence to suggest that this is not the case. It is important to ensure that this assumption is correct, because a different set of accounting rules would be adopted if its immediate future is uncertain. The Materiality Concept Strict application of the various accounting rules may not always be practical. It could involve work that may be out of proportion to the information that is eventually obtained. The materiality rule permits other rules to be ignored if the effects are not considered to be MATERIAL, that is, if they are not significant. If a certain item is IMMATERIAL, then it does not matter how it is shown in the accounts, because it cannot possibly have any effect on the results. The Accruals Concept A misleading impression would be given if the cash received was simply compared with the cash paid out during the same period. Account must also be taken for amounts owed to an organization at the end of an accounting period and amounts payable by the organization at the end of that same period. Such a system enables all the incomes of one period to be MATCHED fairly against all the costs of the same period.

The Main Accounting Concepts II

The Prudence Concept The preparation of the Final Accounts of a particular period must not be overoptimistic and too confident about future events. There may be, for example, undue optimism over the credit-worthiness of a particular customer. Insufficient allowance may, therefore, be made for the possibility of a bad debt. This might have the effect of overstating the profit in one particular period, and understating it in a future period. The Prudence rule is expressed in the form of a simple maxim: IF THERE EXISTS A DOUBT, OVERSTATE LOSSES AND UNDERSTATE PROFITS. The Consistency Concept This rule states that once specific accounting policies have been adopted, then they should be followed in all subsequent accounting periods. It would be considered to be quite unethical to change those rules just because they were unfashionable, or because alternative ones gave better results. Of course, if the circumstances change radically, it may be exceptionally necessary to adopt different policies. The application of this rule gives confidence to users of accounting statements. If the accounts have been prepared on a CONSISTENT BASIS, the users can be assured that they are comparable with previous sets of accounts.

Depreciation on Fixed Assets

In the case of most Fixed Assets except Land and Buildings , it is a fact that the value of such Fixed Assets will diminish over time. This loss of value is called DEPRECIATION, and is a non-financial cost to the company, included with other expenses in the Profit and Loss Account. The three basic causes of depreciation are: Wear and Tear, as things get worn out with use. Obsolescence, as things become out-of-date or old-fashioned. Age, as second-hand assets are not as valuable as brand-new items. The main method of calculating depreciation in accounts is the STRAIGHT-LINE method. Having purchased the fixed asset, the steps involved in determining depreciation are: Estimate the useful life of the asset. Decide if there will be any value at the end of this period termed the residual value The difference between purchase price and residual value is the amount to be written off over the life of the asset. The Straight-Line method involves charging the same amount of depreciation every year. This calculation is made from the following formula:COST - ESTIMATED RESIDUAL VALUE ESTIMATED NUMBER OF YEARS OF USEFUL LIFE

Example of Provision for Depreciation

Eddie bought a van for Lm5,000. He estimated that it would last four years and would be worth Lm200 at the end. To calculate the amount of depreciation to be provided for each of the four years, the formula used is: COST - ESTIMATED RESIDUAL VALUE ESTIMATED NUMBER OF YEARS OF USEFUL LIFE = Lm5,000 - Lm200 4 years = Lm ,200 per annum

Capital and Revenue Expenditure

Capital Expenditure refers to that expenditure incurred in procuring either fixed assets or parts of fixed assets, or else expenses that are required in order to improve the fixed asset or even to start working with the fixed asset. Examples, apart from the purchase price of a fixed asset such as machinery or motor vehicles, include installation charges, training to staff to commence working on the respective machinery, extensions to buildings and other start-up costs. Revenue Expenditure refers to that expenditure incurred by a business in operating the fixed assets. Such expenses include petrol, service and maintenance, repairs (motor vehicles), repairs and maintenance (buildings and machinery) and computer upgrades.

Interpretation of Accounting Statements

Whilst it is useful to be able to describe the contents of a companys accounts, and to be able to say what the words mean, it is possible to get considerably more out of the accounts if these are analysed. In analysing a companys accounts, it is important to determine for which reason these are being seen. For example, if accounts are analysed to determine growth potential, different questions would be asked than if accounts were to be analysed to determine the risks and rewards of identified options. The first step to take in analysing accounts is to classify the different questions to be asked into categories, so that one can focus attention on one aspect of the company at a time. Secondly, the amounts indicated in the financial statements should be reduced to manageable size and converted into ratios. Having determined the ratios, these should then be compared with other similar ratios, because the only sensible way of drawing a conclusion about a ratio is to use it to make a comparison. Once comparisons have been made, it is possible to draw conclusions which enable better views to be derived than before such ratios were determined.

Profitability Ratios
Since it is not possible to tell by a quick glance at the accounts whether any profits made are satisfactory, measures of profitability are available to help us decide. The major ratios used are: Return on Capital Employed (ROCE): Gross Profit to Sales: Net Profit to Sales: Earnings per Share: Dividend per Share: Dividend Cover: Dividend Yield: x100% Net Profit Total Capital Employed x 100% Gross Profit Sales Net Profit x 100% Sales Profit after tax and dividends Number of Issued Ordinary Shares Total Dividends payable Number of Issued shares Earnings per share Dividend per share Dividend per share x 100% Market price per share

Liquidity Ratios
Liquidity ratios attempt to determine a companys financial health. Such ratios help us decide whether the company is in danger of being short of money to meet debts. The major ratios used are: Current Ratio: Current Assets Current Liabilities Current Assets - Stock Current Liabilities Total Profit Interest Paid Fixed Assets (at book value) All medium and long-term debt

Acid Test Ratio:

Interest Cover:

Loan Cover:

Gearing
Gearing analyses a companys capital structure. In other words, through gearing it is possible to determine how much of the total capital employed is owned by shareholders, and how much of it is owed to third parties through loans, long-term credits and other long-term liabilities. Such a position is found through a single ratio: Total Borrowed Capital x 100% Total Share Capital The question of whether high gearing is better than low gearing is not a clearcut case. In times of high profitability, high gearing is preferred since less shareholding will eventually result in higher dividends being earned. However, in times of low profitability, companies with high levels of borrowing are at risk since their commitments will have to be met, irrespective of the levels of profits earned. It is very difficult to determine which is the acceptable level of gearing, as this depends on the company, its products, markets, industry life cycle, how much risk the owners and directors of the company are prepared to take. Gearing Ratio:

Example of Interpretation of Accounting Statements

The following figures are for AB Engineering Supplies Ltd at 31st December 1999 Lm000s Turnover 160 Gross Profit 40 Expenses 8 Fixed Assets Current Assets Stock Debtors Bank Current liabilities Capital Calculate: (i) Gross Profit as a percentage of Sales (ii) Net Profit as a percentage of Sales (iii) Net Profit as a percentage of Total Capital Employed (iv) Current Ratio (v) Acid Test Ratio 108 10 8 2

20 128 10 118 128

Solution to Example of Interpretation of Accounting Statements

Gross Profit as a percentage of Sales: Gross Profit x 100% = 40 x 100% = 25% Sales 160 Net Profit as a percentage of Sales: Net Profit x 100% = (40 - 8) x 100% = 20% Sales 160 Net Profit as a percentage of Total Capital Employed: x 100% = (40 - 8) Net Profit Fixed Assets + Current Assets 128 Current Ratio: Current Assets Current Liabilities

x 100% = 25%

= 20 = 2 : 1 10

Acid Test Ratio: Current Assets - Stock = (20 - 10) = 1 : 1 Current Liabilities 10

Question Two
The summarized accounts of Hope Ltd for the years 1998 and 1999 are given below. Calculate the following ratios for 1998 and 1999: Gross Profit as a percentage of Sales Net Profit as a percentage of Sales Current Ratio Acid Test Ratio Net Profit as a percentage of Capital Employed Expenses as a percentage of Sales Sales as a percentage of Capital Employed
Trading and Profit and Loss Accounts for the year ended 1st 1998 1999 s Lm s Lm Sales 8 Less C ost of Sales 1 1 Gross Profit Less Administration Expenses 8 Less ebenture nterest N et Profit 1 alance Sheets as at 1st ecember 1998 1999 Lm s Lm s 1 1 ixed assets 1 Stoc ebtors 1 an 1 1 1 ecember

rdinary Share C apital Profit and Loss Account 8 ebentures C reditors an verdraft

1998 1999 Lm s Lm s 11 1 8

Budgets and Budgetary Control

A budget is a statement which expresses somebodys plans in quantitative, usually monetary, terms. The purpose of a budget is to give a manager the chance to determine for himself precisely how the part of the company for which he is responsible will perform. A budget also enables the Finance Department to plan how much money to borrow or invest at different times of the year. Individual departmental budgets form the basis by which total operating and financial plans can be made, as well as providing individual managers with a measure of their own performance. Apart from companies, budgets may also be used on a personal basis for individuals private affairs; income and expenditure are estimated and balanced to ensure that they have enough money in the bank. Budgetary Control is the name given to the control system which uses budgets as the basis for monitoring actual performance.

Key elements of a good control system

There must be a plan, which may be expressed as a target, which must be capable of being compared with what is actually happening. Performance must be monitored as planned performance is compared with what is actually happening. For such monitoring to take place, the accounting information in the budget must be presented in the same way as the information in the actual accounts. Such monitoring must be made often to ensure that any variations between planned performance and actual events are identified before serious effects occur. Variances must be reported to the responsible manager, representing a feedback loop. All significant variances should then be fed back to the person responsible for the respective budget, in order to determine the cause and what action will be taken to make up for the variance. A decision must be taken by the responsible manager with regards to the action to take. Such action will be a choice from three options: do nothing at all, change the planned budget, or adjust operations. Often an adverse variance is used as a way of checking a managers performance. On the other hand, if the variance is favourable, too often nothing is said or done. When things are going according to plan, it is worth informing the people involved of the good news, as this has a threefold effect: it stops them worrying, it helps them resist the temptation to overbudget, and they feel good.

The Benefits of Budgeting

The following benefits may be derived from the budgeting process: Planning and Coordination. Planning is the key to success in business and budgeting forces planning to take place. Moreover, budgeting provides for the coordination of the activities and departments of the organisation so that each facet of the operation contributes towards the overall plan. Clarification of Authority and Responsibility. Budgeting makes it necessary to clarify the responsibilities of each manager who is responsible for a budget. As a result, employees are able to clarify the authority and responsibility channels within which they have to work. Communication. Since the budgetary process involves all levels of management, this is an important avenue of communication between top and middle management regarding the companys objectives and practical problems of implementing such objectives. Budgeting also communicates the agreed plans to all staff involved to ensure that coordination is achieved. Control. The process of comparing actual results with planned results and reporting on the variations sets a control framework which helps expenditure to be kept within agreed limits. Motivation.The involvement of lower and middle management in preparing budgets and establishing clear targets against which performance is judged have been found to be motivating factors.

Typical problems which may arise with budgeting

The following problems may also arise during the budgeting process: Variances are frequent due to changing circumstances. Budgets are developed around existing organisation structures which may be inappropriate for current conditions. The existence of well documented plans may cause inertia and lack of flexibility in adapting to change. Badly handled budgetary systems which cause undue pressure or lack of regard to human resources may cause antagonism and may lower morale.

Master Budget
The Master Budget refers to the overall Budgeted Operating Statements (normally the Profit and Loss Account and the Balance Sheet), which is composed of the different budgets that are compiled by the different departments. The following relates to the relationships between the major budgets in a manufacturing company:

i rect Labou r B ud get

M aterial B ud get

sage

P urchases B ud get

r editors B ud get

a sh B ud get M aster B ud get ( ie B ud geted P ro fit and Loss A ccount and B alan ce S heet

A dm inistration o sts B udget

e btors B ud get

S ales B ud get

S elling & i stribution B udget

e search & e velopm ent B ud get


a pital B ud get

inished o ods S toc B ud get

P roduction B ud get

P roduction O verheads B ud get p enditure

Main Budgets
The main budgets that are normally developed are the following: Sales Budget, incorporating the expected amount of sales revenues from the different products and/or services that the company sells. Production Budget, which shows the different estimated costs of production from labour, materials and overheads expenses. Normally the Production Budget derives a production cost per unit, which is then used in defining the total cost of goods sold. Capital Expenditure Budget, which indicates the major capital costs that are expected to be incurred during the budget period. As capital expenditure affects cash flows, this budget represents an important input to identifying cash available for investments. Cash Budget, which illustrates the companys liquidity expected positions throughout the budgeted period.

Limiting Factor or Principal Budget Factor

The limiting factor is that factor which at any given time effectively limits a companys activity. Such a factor may be customer demand, production capacity, shortage of labour or materials, space or finance. Because this factor constrains all plans and budgets, the limiting factor must be identified together with its effect on each of the budgets considered during the budget preparation process. Frequently, the limiting factor is customer demand or sales revenue, since a company normally has a specified market share. The company is therefore unable to sell all the output it can produce. The limiting factor can and does change, as when one constraint is removed some other limitation will occur. Therefore, any increase in market share will not necessarily enable the company to increase production, as this may be limited in production capacity.

Example of Budgets
R Ltd manufactures three products: A, B and C. Using the following information, you are required to prepare budgets for the month of January for: (i) sales in quantity and value; (ii) production quantities; (iii) material usage in quantities; (iv) material purchases in quantity and value. Product Quantity Price each Sales A 1,000 Lm100 B 2,000 Lm120 C 1,500 Lm140 Materials used in the companys products are: Material M1 M2 Unit Cost Lm4 Lm6 Quantities used in units: Product A 4 2 Product B 3 3 Product C 2 1 Finished Stocks: Product Quantities at 1st January Quantities at 31st January Material Stocks: Quantities at 1st January Quantities at 31st January A 1,000 1,100 M1 26,000 31,200 B 1,500 1,650 M2 20,000 24,000

M3 Lm9 -2 1

C 500 550 M3 12,000 14,400

Solution to Example of Budgets

(i) Sales Budget Products A Sales quantities (units) Selling Price (per unit) Sales Value 1,000 Lm100 Lm100,000 B 2,000 Lm120 Lm240,000 C 1,500 Lm140 Lm210,000 Lm550,000 Total Value

(ii) Production Budget Products A Sales (units) Add Closing Stock Less Opening Stock Required Production 1,000 1,100 2,100 (1,000) 1,100 (iii) Material Usage Budget Production Budget M1 Units A B 1,100 2,150 4 3 2 Total 4,400 6,450 3,100 13,950 Units 2 3 1 Materials M2 Total 2,200 6,450 1,550 10,200 Units Nil 2 1 M3 Total Nil 4,300 1,550 5,850 B 2,000 1,650 3,650 (1,500) 2,150 C 1,500 550 2,050 (500) 1,550

C 1,550 Material Usage

(iv) Material Purchases Budget Materials M1 Usage from budget Add Closing Stock Less Opening Stock Required Purchases Unit Cost Value of Purchases Lm4 Lm76,600 13,950 31,200 45,150 (26,000) 19,150 Lm6 Lm85,200 M2 10,200 24,000 34,200 (20,000) 14,200 Lm9 Lm74,250 Lm236,050 M3 5,850 14,400 20,250 (12,000) 8,250 Total

Variance Analysis
A variance is the difference between the standard or budgeted cost, and the actual cost incurred. The only purpose of variance analysis is to provide practical information on the causes of adverse company performance, so that management can improve operations, increase efficiency, utilise resources more effectively and reduce costs. The only criteria used to determine whether a variance should be calculated or not is its usefulness. If the variance to be calculated is not useful for management purposes, it should not be produced. Variances are qualified into three main areas: Labour, Materials and Overheads. Variances may be adverse (actual cost greater than standard) or favourable (actual cost less than standard) Each variance may be calculated according to two measurement criteria: price or rate, and usage.

Labour Variances
Labour variances arise from the different wage rates paid as well as the longer or shorter times required to produce the actual quantities produced. There are three labour variances normally calculated: Direct Labour Rate Variance: defined as the difference between the standard and actual direct labour hour rate per hour for the total hours worked.
(Actual labour hours x Actual rate) - (Actual labour hours x Standard rate)

Direct Labour Efficiency Variance: defined as the difference between the standard hours for the actual production achieved and the hours actually worked, valued at the standard labour rate.
(Actual labour hours x Standard rate) - (Standard labour hours x Standard rate)

Direct Labour Total Variance: defined as the difference between the standard direct labour cost and the actual direct labour cost incurred for the production achieved.
This is found by adding the Direct Labour Rate and Direct Labour Efficiency variances

Materials Variances
Materials are charged to production at the standard price. Variances are subsequently calculated as they arise, resulting in a price variance which may be related to individual functions. There are three materials variances normally calculated: Direct Materials Price Variance: defined as the difference between the standard price and actual purchase price for the actual quantity of material.
(Actual purchase quantity x Actual price) - (Actual purchase quantity x Standard price)

Direct Materials Usage Variance: defined as the difference between the standard quantity specified for the actual production and the actual quantity used, at standard purchase price.
(Actual quantity used x Standard price) - (Standard quantity used x Standard Price)

Direct Materials Total Variance: defined as the difference between the standard direct material cost of the actual production volume and the actual cost of direct material.
This is found by adding the Direct Materials Price and Direct Materials Usage variances

Fixed Overheads Variances I

Fixed overhead variances relate to those overheads which are fixed in nature, and relate to those expenses that are frequently incurred in equal amounts. Fixed overheads are normally absorbed into production costs, resulting in the calculation of a Fixed Overhead Absorption Rate. This is found by dividing the budgeted fixed overheads with the standard hours produced. There are five fixed overheads variances normally calculated: Fixed Overhead Expenditure Variance: defined as the difference between the budget cost allowance for production for a specified control period and the actual fixed expenditure attributed and charged to that period. (Actual expenditure on fixed overheads) - (Budgeted fixed overheads) Fixed Overhead Efficiency Variance: defined as the difference between the standard cost absorbed in the production achieved and the actual direct labour hours worked. (Actual labour hours x Fixed Overhead Absorption Rate) - (Standard labour hours x Fixed Overhead Absorption Rate)

Fixed Overheads Variances II

Fixed Overhead Capacity Variance: defined as that portion of the fixed production overhead volume which is due to working at higher or lower capacity than the standard. (Budgeted Fixed Overheads) - (Actual labour hours x Fixed Overhead Absorption Rate) Fixed Overhead Volume Variance: defined as the difference between the standard cost absorbed in the production achieved and the budget cost allowance for a specified control period. This is the found by adding the Fixed Overhead Efficiency and Fixed Overhead Capacity variances Fixed Overhead Variance: defined as the difference between the standard cost of fixed overhead absorbed in the production achieved and the fixed overhead attributed and charged to that period. This is found by adding the Fixed Overhead Expenditure and Fixed Overhead Volume variances

Variable Overheads Variances

Variable overhead variances cover those overheads that are of a variable nature. In other words, variable overheads are related to the level of production, and are not timebased or fixed in any other way. Variable Overheads are normally absorbed into production costs, resulting in the calculation of a Variable Overhead Absorption Rate. This is found by dividing the budgeted variable overheads with the standard hours produced. There are three variable overheads variances normally calculated: Variable Overhead Expenditure Variance: defined as the difference between the actual variable overheads incurred and the allowed variable overheads based on the actual hours worked.
(Actual variable overheads) - (Actual labour hours x Variable Overhead Absorption Rate)

Variable Overhead Efficiency Variance: defined as the difference between the allowed variable overheads and the absorbed variable overhead.
(Actual labour hours x Variable Overhead Absorption Rate) - (Standard labour hours x Variable Overhead Absorption Rate)

Total Variable Overhead Variance: defined as the difference between the actual variable overheads incurred and the variable overheads absorbed.
This is found by adding the Variable Overhead Expenditure and Variable Overhead Efficiency variances

Example of Variances I
The following is an abstract from the Standard Cost Card for Part No. 100X, and actual results for the month of May: Standard Cost Card (abstract) Part No. 100X Standard Cost/Unit Raw Materials 50Kgs @ Lm2.50/Kg Lm125 Direct Labour 14 hours @ Lm2.75/hour Lm 38.50 Lm163.50 Actual Results for May Production Direct Material Purchases Opening Stock Direct Materials Closing Stock Direct Materials Wages paid (2020 hours)

150 units 7000 Kgs at a cost of Lm18,200 1300 Kgs 850 Kgs Lm5,858

Solution to Example of Variances I

Direct Labour Rate Variance (Actual labour hours x Actual rate) - (Actual labour hours x Standard rate) (Lm5,858) - (2020 hours @ Lm2.75) = Lm303 Adverse Direct Labour Efficiency Variance (Actual labour hours x Standard rate) - (Standard labour hours x Standard rate) (2020 hours @ Lm2.75) - (150 x 14) hours @ Lm2.75 = Lm220 Favourable Direct Labour Total Variance Direct Labour Rate Variance + Direct Labour Efficiency Variance = Lm303 Adverse + Lm220 Favourable = Lm83 Adverse Direct Materials Price Variance (Actual purchase quantity x Actual price) - (Actual purchase quantity x Standard price) (Lm18,200) - (7000 Kgs @ Lm2.50) = Lm700 Adverse Direct Materials Usage Variance (Actual quantity used x Standard price) - (Standard quantity used x Standard Price) (7450 Kgs @ Lm2.50) - (150 x 50) @ Lm2.50 = Lm125 Favourable Direct Materials Total Variance Direct Materials Price Variance + Direct Materials Usage Variance Lm700 Adverse + Lm125 Favourable = Lm575 Adverse

Example of Variances II
The following data refers to budgeted and actual results of February for Department Number 82:
Budget for February: Department No. 82 Fixed Overheads Lm11,480 Variable Overheads Lm13,120 Labour Hours 3,280 Hours Standard Hours of Production 3,280 Hours Actual results for February: Department No. 82 Fixed Overheads Lm12,100 Variable Overheads Lm13,930 Actual Labour Hours 3,150 Standard Hours Produced 3,230

Solution to Example of Variances II

Based on the budgeted figures, the overhead absorption rates are calculated as follows:
= Budgeted Fixed Overheads = Lm11,460 = Lm3.50 per hour Budgeted Activity Level 3280 Std Hours Variable Overhead Absorption Rate = Budgeted variable overheads = Lm13,120 = Lm4 per hour Budgeted Activity Level 3280 Std Hours Fixed Overhead Absorption Rate

Fixed Overhead Expenditure Variance (Actual expenditure on fixed overheads) - (Budgeted fixed overheads) = (Lm12,100) - (Lm11,480) = Lm620 Adverse Fixed Overhead Efficiency Variance (Actual labour hours x Fixed Overhead Absorption Rate) - (Standard labour hours x Fixed Overhead Absorption Rate) = (3150 x Lm3.50) - (3230 x Lm3.50) = Lm280 Favourable Fixed Overhead Capacity Variance (Budgeted Fixed Overheads) - (Actual labour hours x Fixed Overhead Absorption Rate) = (Lm11,480) - (3150 x Lm3.50) = Lm455 Adverse

Solution to Example of Variances II ...continued

Fixed Overhead Volume Variance Fixed Overhead Efficiency Variance + Fixed Overhead Capacity Variance = Lm280 Favourable + Lm455 Adverse = Lm175 Adverse Fixed Overhead Variance Fixed Overhead Expenditure Variance + Fixed Overhead Volume Variance = Lm620 Adverse + Lm175 Adverse = Lm 795 Adverse Variable Overhead Expenditure Variance (Actual variable overheads) - (Actual labour hours x Variable Overhead Absorption Rate) = (Lm13,930) - (3150 x Lm4) = Lm1330 Adverse Variable Overhead Efficiency Variance (Actual labour hours x Variable Overhead Absorption Rate) - (Standard labour hours x Variable Overhead Absorption Rate) = (3150 x Lm4) - (3230 x Lm4) = Lm320 Favourable Total Variable Overhead Variance Variable Overhead Expenditure Variance + Variable Overhead Efficiency Variance = Lm1330 Adverse + Lm320 Favourable = Lm1010 Adverse

Question Three
For Product X, the following data is given: Standards per unit of product:
Direct Material 4 Kg @ Lm0.75 per Kg Direct Labour 2 Hours @Lm1.60 per Hour

Actual details for given financial period:

Output produced: Direct materials purchased: Direct materials issued to production: Direct Labour: 38,000 units 180,000 Kgs for Lm126,000 154,000 Kgs 78,000 hours worked for Lm136,500

You are required to calculate the following variances:

direct materials total direct materials price, based on issues to production direct materials usage direct labour total direct labour rate direct labour efficiency

Sources of Finance I
An organization may raise finance from different sources: Owners capital. Many organizations start with the owner s putting into the business some or all of their money. This capital is used to buy assets which the organizations subsequently use in the daily operations of the business. Share Capital. If the respective organization is a limited liability company, the capital is divided into shares which are offered to the public for sale. In exchange for their money, shareholders receive a share certificate stating that they have a share in the ownership of the company. Loans. With small companies, loans are often provided from relatives of the owners, whilst in the case of larger companies, banks normally provide a large amount, although loans from individuals are also obtained. All loans are referred to as Loan or Borrowed Capital, and are shown in the Balance Sheet as Long-Term Liabilities.

Sources of Finance II
Suppliers. Rather than obtaining money from suppliers, what happens is that companies normally delay paying their bills, and so has use of its money a little longer than it should. The difficulty with such financing is that suppliers may cease to want to do business with companies adopting this policy, particularly in the case of small companies. Other creditors. Apart from suppliers, most companies find that they owe money but have a while before cash has to be paid out. A typical example is company tax on profits, which is not due until the following year. Dividends are another example, which are paid at the end of the financial year. Retained profits. Once a business is making profits, these become the main source of finance that is generated by the business itself. In fact, what is not paid out to suppliers, government or shareholders is retained within the business for daily operations as an addition to the companys capital.

Capital Budgeting
The allocation of funds for an investment in a project which involves an outflow of money now in return for future inflows is known as capital budgeting. An investment proposal should be judged in relation to whether it provides a return equal to, or greater than, that required by investors. One of managements key roles is the selection of projects on which the income from the investment exceeds the interest costs of its financing. The factors which are taken into account in investment appraisals include (a) the marginal costs and revenues of the project; (b) the source of funds for the project; (c) the certainty of the future cash flows; (d) the timing of the cash flows; (e) the existence of alternative opportunities; (f) taxation; (g) government policy.

Capital Investment Appraisal

One of the most important tasks in capital budgeting is estimating future cash flows for a project. The reason we express the benefits expected in terms of cash flows rather than in terms of income is that cash is what is central to all the decisions of a company. A company invests cash now in the hope of receiving cash returns in a greater amount in the future. Only cash receipts can be re-invested in the company or paid to shareholders in the form of dividends. For each investment proposal, we need to provide information on expected future cash flows on an after-tax basis. In addition, the information must be provided on an incremental basis so that we analyse only the difference between the cash flows of the firm with and without the project.

Cash Flows versus Book Values

We are considering the purchase of a machine to replace an old one. The information available is the following: Purchase price of new machine: Lm18,500 Cost of installation: Lm1,500 Life of new machine: 5 years Scrap Value: Nil The old machine can be sold for its book value of Lm2,000. Yearly cash savings before tax of the new machine is Lm7,600. We assume that the old machine had 5 more years to run, and that the depreciation is on a straight-line basis (i.e. Lm400 per annum) On the new machine, depreciation is also spread over 5 years and is therefore Lm4,000 per annum. Because we are interested in the incremental impact of the project, we must subtract depreciation charges on the old machine from depreciation charges on the new one to obtain the incremental depreciation charges associated with the project: Cash Flow Account (Lm) Book Account (Lm) Annual Cash Savings 7,600 7,600 less Incremental Depreciation (3,600) Additional income before tax 4,000 less Income Tax (17%) (1,300) (1,300) _ Additional income after tax 2,700 Additional Net Cash Flow 6,300

Method One:

Accounting Rate of Return

The Accounting Rate of Return represents the average annual profits after taxes to the average investment in the project. The main advantages of this method are that it is simple to calculate; and the fact that it makes use of readily available accounting information, thus allowing it to be more easily understood by non-financial people. The disadvantages of this method include the fact that it fails to allow for the timing of cash flows; and since it is an average, it gives no weight to the duration of the earnings. Moreover, it is based upon profits and not cash flows, whereby the former are less relevant than the latter in calculating the returns on investments made.

Example of Accounting Rate of Return

We are considering three projects with an initial investment of Lm500, zero scrap value, a life of 5 years, and the following profits, net of tax and depreciation:
Year 1 2 3 4 5 Project A Lm 50 50 50 50 50 250 Project B Lm 0 25 50 75 100 250 Project C Lm 100 75 50 25 0 250

Calculate: (a) the Return on Initial capital; (b) the Return on Average capital. (a) The Return on Initial Capital
1/5 x 250 500 10% 1/5 x 250 500 10% 1/5 x 250 500 10%

(b) The Return on Average Capital The average capital is calculated by reference to the opening and closing book values:
i.e. 500 + 0 2 = Lm250

The rate of return on all projects is therefore: 1/5 x 250 = 20% 1/2 x 500

Method Two:

Payback

The payback period is the time it takes for the cash inflows from a project to amount to the cash outflows. It is one of the most frequently used methods of measuring the worth of an investment opportunity. The inflows involved are the average net incremental cash flows, meaning the increase in revenue plus the savings, if any, in marginal costs. The earnings to be taken are those after tax, since tax payments diminsh the net cash inflow, but before depreciation, since the provision for depreciation is purely a book-keeping transaction with no effect on cash flows. Under this method, the question is: How soon can we expect to recover the capital invested in the project? The main advantages of this method are that it is simple to calculate and easily understood by non-financial people, and when investment conditions are expected to improve in the near future, attention is directed to those projects which will release funds soonest to take advantage of the improving climate. The main disadvantages of this method are that it ignores cashflows after the payback period, and is hence biased against long-term investments. Moreover, as the payback method assumes all cash flows to be equally certain, no formal assessment is given to the risk factor. Normally, estimates of cash flows are likely to be less reliable the further into the future they are made.

Example of Payback
It is proposed to introduce a new machine to increase production capacity. Two machines are available, Type A and Type B. The following information is available: Type A Type B Cost of machine Lm30,000 Lm63,000 Estimated life (years) 5 10 Increase in revenue per annum Lm3,000 Lm4,000 No. of operators saved 9 11 Average earnings of operators per annum Lm500 Lm500 Additional maintenance costs Lm1,000 Lm1,500 Expected savings in indirect materials Lm500 Lm200 Expected savings in scrap losses Lm500 Lm800 Statement of expected returns: Estimated working life Outflow (cost of machine) Inflows: Increase in revenue per annum: Savings in direct labour costs Indirect labour costs Indirect Material savings Scrap losses savings Payback period in years

5 years Lm30,000 Lm3,000 Lm4,500 (Lm1,000) Lm500 Lm500 Lm7,500 4

10 years Lm63,000 Lm4,000 Lm5,500 (Lm1,500) Lm200 Lm800 Lm9,000 7

Method Three: Discounted Cash Flows

A major disadvantage of both the Payback technique and the Accounting Rate of Return is their failure to take account of the time value of money. People prefer money now rather than in the future for four reasons:
Ability to spend it, since money held now can be spent immediately. Reduction of risk: until the money is received, there is a risk that the offer may collapse. Opportunity cost: money held now can be used within the business for expansion. Ability to invest: even if the money is not required now, it could be invested to accumulate a larger sum in the future.

If an investment is offering 10% per annum interest payable annually, then the value of Lm1 at the end of the first year would be Lm1.10. Provided that the money was left on deposit at this rate, the value at the end of the second year would be Lm1.10 plus 10% of the re-invested sum of Lm1.10, equivalent to Lm1.21, and so on for successive years. In calculating discounted cash flows, all expected cash flows are discounted to present value using the required rate of return. If the sum of these discounted cash flows is equal to, or greater than, zero, the proposal is accepted. In other words, the project will be accepted if the present value of cash inflows exceeds the present value of cash outflows.

Present Value of Lm due at the end of N years

N 1 2 3 4 5 6 7 8 9 10 5% 0.95238 0.90703 0.86384 0.82270 0.78353 0.74622 0.71068 0.67684 0.64461 0.61391 6% 0.94340 0.89000 0.83962 0.79209 0.74726 0.70496 0.66506 0.62741 0.59190 0.55839 7% 0.93458 0.87344 0.81630 0.76290 0.71299 0.66634 0.62275 0.58201 0.54393 0.50835 8% 0.92593 0.85734 0.79383 0.73503 0.68058 0.63017 0.58349 0.54027 0.50025 0.46319 9% 0.91743 0.84168 0.77218 0.70843 0.64993 0.59627 0.54703 0.50187 0.46043 0.42241 10% 0.90909 0.82645 0.75131 0.68301 0.62092 0.56447 0.51316 0.46651 0.42410 0.38554 11% 0.9009 0.81162 0.73119 0.65873 0.59345 0.53464 0.48166 0.43393 0.39092 0.35218 12% 0.89286 0.79719 0.71178 0.63552 0.56743 0.50663 0.45235 0.40388 0.36061 0.32197 13% 0.88496 0.78315 0.69305 0.61332 0.54276 0.48032 0.42506 0.37616 0.33288 0.29459 14% 0.87719 0.76947 0.67497 0.59208 0.51937 0.45559 0.39964 0.35056 0.30751 0.26974 15% 0.86957 0.75614 0.65752 0.57175 0.49718 0.43233 0.37594 0.32690 0.28426 0.24718 16% 0.86207 0.74316 0.64066 0.55229 0.47611 0.41044 0.35383 0.30503 0.26295 0.22668 17% 0.8547 0.73051 0.62437 0.53365 0.45611 0.38984 0.33320 0.28487 0.24340 0.20804 18% 0.84746 0.71818 0.60863 0.51579 0.43711 0.37043 0.31392 0.26604 0.22546 0.19106 19% 0.84034 0.70616 0.59342 0.49867 0.41905 0.35214 0.29592 0.24867 0.20897 0.17560 20% 0.83333 0.69444 0.57870 0.48225 0.40188 0.33490 0.27908 0.23257 0.19381 0.16151

Example of Discounted Cash Flow

X Ltd is considering its capital investment programme. It will have to pay 10% per annum to borrow any money required for investment. The following table shows the net cash flow per annum associated with three different projects, each having the same initial capital cost of Lm20,000. Evaluate the ranking of each project: Net Cash Flows Year 1 (Lm) Project A Project B Project C 10,000 12,000 16,000 Year 2(Lm) 10,000 16,000 16,000 Year 3(Lm) 10,000 10,000 Nil

Solution to Example of Discounted Cash Flow

Year Discounting Factor Project A Project B Project C at 10% Net Cash Flow Present Value Net Cash Flow Present Value Net Cash Flow Present Value 1 0.9091 10,000 9,091 12,000 10,909 16,000 14,546 2 0.8264 10,000 8,264 16,000 13,222 16,000 13,222 3 0.7513 10,000 7,513 10,000 7,513 NIL NIL Gross Present Value 24,868 31,644 27,768 Cost (20,000) (20,000) (20,000) Net Present Value 4,868 11,644 7,768 Ranking 3 1 2

Note that the relative desirability of the projects would change with changes in the discount rate. The higher the discount rate, the more attractive would be the project with the early cash inflows. The lower the rate, the less important is the timing of the cash flows and the more valued is the proposal with the greatest absolute amount of cash inflows.

Question Four
A proposal has come before the Board of Directors of Solera Ltd for the purchase of a machine to manufacture a new product. The expected results for the five year life of the machine are as follows: Year 1 Lm Sales Direct Costs Depreciation Total Costs Profit/Loss 20,000 10,000 6,000 16,000 4,000 Year 2 Lm 22,000 12,000 6,000 18,000 4,000 Year 3 Lm 23,000 13,000 6,000 19,000 4,000 Year 4 Lm 16,000 10,000 6,000 16,000 NIL Year 5 Lm 12,000 8,000 6,000 14,000 (2,000)

Soleras cost of capital is 12% per annum. Would you advise the company to invest in this machine?

The Cost Centre Concept

A Cost Centre may be defined as a location, function or items of equipment in respect of which costs may be ascertained and related to cost units for control purposes. In practice, a cost centre is simply a method by which costs are gathered together, according to their incidence, usually by means of cost centre codes.
Cost Centre Number 100 110 120 130 150 200 250 310 350 400 405 410 415 420 445 510 515 520 525 530 535 540 550 701 703 706 707 708 710 720 725 730 790 800 805 Cost Centre Name Board Secretariat & Com pliance Unit Chairm an's Office General Manager's Office Executive Directors Legal Departm ent Strategic Bus ines s Developm ent Unit Bus ines s Continuity Finance Departm ent Credit Control Sales Office Cus tom er Services Unit Marketing Office Cardphones Directory Gozo Office General Adm inis tration Ris k Managem ent Contracts & Procurem ent Facilities Managem ent Unit Utilities Services Stores Trans port Hum an Res ources Managem ent Office of AGM Acces s Networks Infras tructural Works Gozo Operations & Maintenance - Acces s Networks Shareholders Relations Operations & Maintenance - Switching Trans m is s ion Departm ent International Departm ent Central Engineering Services I.T. Departm ent Annual General Meeting Internal Audit Head of Cost Centre Ray Fava Ivo Galea Joe Azzopardi Edgar Borg Dr Mario Caruana Eng R Azzopardi Caffari Eng P Montanaro Brenda Azzopardi Peter Mifs ud Charles Zam m it Charles Zam m it Charles Sacco Alfred Scicluna Lino Agius Mus cat Edward Mizzi Jes m ond Cam illeri Frank St John Ray Cini Jes m ond Cam illeri Joe Briffa Mario Tabone Saviour Seychell Karm enu Mifs ud Eng M Cachia Saviour Portelli Eng S Debrincat Eng. J. Pace John Grim a Calleja Eng. A. Ghigo Eng. A. Cas s ar Eng. M. Farrugia Eng J. Agius Eng. S. Baldacchino Ray Fava Ingrid Azzopardi

Cost Allocation and Apportionment

Cost Allocation refers to the charging of identifiable items of costs to cost centres. In other words, where a cost, without division or splitting, can be clearly identified with a cost centre, then it can be allocated to that cost centre. It follows that direct costs, such as wages salaries, cables and other materials can be allocated to particular cost centres. However, cost allocation can equally apply to indirect costs such as computers, stationery, water and electricity and rent of premises. Although sometimes it is not possible to identify an item of cost with a cost centre, it is necessary to split a cost over several cost centres on some agreed basis. Rent and Water and Electricity, for example, are normally apportioned according to the floor area occupied by the various cost centres. The basis upon which the apportionment is made varies from cost to cost. The basis chosen should produce, as far as possible, a fair and equitable share of the common cost for each of the receiving cost centres. The choice of an appropriate basis is a matter of judgement to suit the particular circumstances of the organization and wherever possible there should be a cost/cause relationship.

Typical Cost Apportionments

Basis Floor Area Volume or Space Occupeid Number of Employees in each Cost Centre Book Value of Plant, Equipment, Premises, etc Stores Requisitions Weight of Materials Costs which may be apportioned on this basis Rates, Rent, Heating, Cleaning, Lighting, Building Depreciation Heating, Lighting, Building Depreciation Canteen, Welfare, Personnel, Safety, General Administration, Industrial Relations Insurance, Depreciation Store-keeping Store-keeping, Materials Handling