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MBA Intensive Seminars 2004

FMA

Revision notes

MBA INTENSIVE SEMINARS 2004 Page 1


Definition
Accounting is the process of
•identifying,
•measuring
•and communicating
•financial information about an entity
•to permit informed judgments and decisions
•by users of the information.
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The Accounting Equation
Assets minus Liabilities equals Equity
A - L = E
Assets equals Liabilities plus Equity
A = L + E

Equity Capital Ownership claim


Shareholders’ funds
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Power of Accounting
“Accounting provides a very selective but powerful
representation of the corporate identity..”

“The detailed language of assets, liabilities, costs, profits


provide a range of corporate imagery and vocabulary …….

“Accounting provides the categories through which


organisational participants perceive both themselves and
the organisation.”

Mike Powers
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Creative Accounting?
“Things may exist independently of our accounts, but they
have no human existence until they become accountable.
They may not exist, but they take on human significance by
becoming accountable..”
“Accounts define reality and at the same time they are that
reality….”
“Accounts do not more or less accurately describe things.
Instead they establish what is accountable in the setting in
which they occur”

“Whether they are ACCURATE OR INACCURATE by some other


standards, accounts define reality for a situation in the sense
that people act on the basis of what is accountable in the
situation of their action.”
Ruth Hines
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You will discover
That accounting is subjective, partial and
potentially misleading
Accountants use language / numbers in a highly technical
way
Accounts are a highly stylised story, representation,
description of organisational events

Differences between the ‘Accounting World’


and the ‘Organisational World’
Problematic nature of accounting numbers
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And there’s more….
The tribe of accountants takes many forms and lives
within all organisations

No such thing as a correct ‘cost’, ‘value’, ‘profit’..it


all depends on context
The value of accounting in managing
organisations

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Roles of Accounting
Improve problem solving / decision making
Manage risks
Trust, Assurance
Educational - learn about organisations
Language of business
Construct, define, measure success/failure

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Roles of Accountants
Assisting the internal management of organisations

Complying with external financial reporting,


controls and with taxation regulations

Expert consultants on financial and organisational


performance

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Financial Accounting
Accounting concepts

Profit and Cash distinction

Financial statements

Organisational impact

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Hierarchy of Accounting Qualities
Decision Makers and their characteristics

Benefits > Costs

Understandability

Decision-Usefulness

Relevance Reliability

Predictive Timeliness Verifiability Representational


value
Faithfulness
Comparability &
Feedback consistency Neutrality
Value
Materiality

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Transactions
Buy materials on credit
from suppliers
Sell goods or services on
credit to customers
Pay suppliers

Receive cash
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When is profit reported?

When goods or services are sold


NOT
when cash is paid or received

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Example: Antiques dealer

Buy 10 chairs for cash $200 each


Sell 6 chairs on credit $300 each

Profit 6 x $100 each = $600


Cash flow = minus $2,000
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Profit, not cash
Matching Concept – match revenues received with
the costs incurred to generate them
Goods received but not paid for –Creditors
(Payables)
Goods or services supplied but no cash yet - Debtors
(Receivables)
Prudence concept – providing for known / probable
losses – e.g. Doubtful debts, Depreciation of fixed assets
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Profit, not cash contd
Customers pay in advance for services extending
beyond the accounting period

Company agrees with supplier to buy


materials at fixed price for 5 years

Home currency euros, borrow in dollars


Increase in valuation of fixed assets

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Change over a period
start Assets - Liabilities = Equity

During the period Profit/loss


end Assets - Liabilities = Equity

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Contents of annual report
Financial highlights
Company overview
Chairman’s statement
Chief Executive’s review
Audit report
Financial statements
Notes to the accounts
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The main financial statements
Balance Balance Balance
Sheet 1 Sheet 2 Sheet 3
AS AT AS AT AS AT
31 Dec Year 1 31 Dec Year 2 31 Dec Year 3

Profit and Loss Profit and Loss


Account Account
For period For period

Cash Flow Report Cash Flow Report

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Balance sheet horizontal
• Fixed assets • Liabilities

• Current assets • Shareholders’ funds

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Balance sheet vertical
Fixed assets

Current assets
Less
Current liabilities

Less long term liabilities

Equals
Shareholders’ funds

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Profit and loss account
Revenue (sales)

Less Expenses (costs)

Equals Profit

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Cash flow statement
Operating cash flows

plus
Investing cash flows
plus
Financing cash flows
Equals change in cash and bank loans
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Creative accounting

What do we want to create?

More profit? Less profit?

More assets? Fewer assets?

More liabilities? Fewer liabilities?


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Creative Accounting Practices
Income smoothing – move profit from one year to
another
Changing accounting policies, particularly
depreciation, asset valuations

Overstating costs, particularly in regulated industries

Making expenses into Assets - ‘capitalisation’


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Off-balance sheet financing , e.g leasing, Sale
and buyback, special purpose vehicles

Recognising profits that aren’t really there –


foreign exchange rates affecting values of
assets and loans

Corporate takeovers – ACCOUNTING


MINEFIELD adjusting policies, fair values,
goodwill, brands, reorganisation costs……...
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Corporate crime / fraud
Directors are responsible for preventing crime and
fraud
They are required to have a system of internal
controls
Who controls executive directors for honesty/?
Audit committees, Non-executive Directors,
Supervisory Board
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Corporate crime/ fraud contd.

Creating fictitious contracts

Fictitious Assets, inaccurate valuations

Omitting Liabilities, misleading valuations

Raid the employees’ pension fund

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Analysis and
Interpretation of
Financial Statements

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First Steps BC
(before calculation)
• Why are you analysing accounts?
• Who are you interpreting for?
• When are you interpreting?
• What are you intending to interpret?
• Limitations of Financial Accounts

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Always bear in mind
• Preparers of accounts know how people will interpret
their accounts
• Be cynical – assume the accounts are the best possible
picture
• Analysis only as good as original data –
• Never just use accounts – check from many different
sources
• Accounting terms are different from general
understandings

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However….
• Accounts are main source of systematically produced
regulated information
• Good as it gets
• Usually reliable – 3rd party verified
• Follow the same basic rules
• Most of the information is there (in the small print)
• You can never eliminate the risk of fraud / criminal
misrepresentation

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Analyse Accounts to determine
Is the company:
•Growing? •Profitable?
•Managing its assets effectively?

•Sufficiently liquid?
•Financed properly?
•Able to meet its financial obligations?
•Viewed favourably by financial markets?
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Financial ratios
• Quick and simple check on financial health
• Small number of ratios gives a picture of the
business. Easy to calculate, harder to interpret.
• Provide a starting point for further investigation.

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Key areas for analysis
• Profitability
• Liquidity
• Asset management
• Debt management (financial structure)
• Market value

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Success in making profit
Return on capital employed
profit sales Profit
_____ x _______ = __________
sales total assets total assets

profitability x efficiency = ROCE

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Managing liquidity
• Can we pay the bills as they fall due?
• Can we pay the wages of employees?
• Buy stock (inventory) on credit
• Sell on credit = accounts receivable
• Pay suppliers = accounts payable
• Ideally, match cash flows in and out

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Asset management
• Use fixed assets to earn sales revenue
• Manage working capital
• stocks (inventory)
• debtors (accounts receivable)
• creditors (accounts payable)
• working capital cycle

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Financial structure
• Is it a good idea to borrow?
• Creates greater risk - interest payments and
capital repayments
• Benefits to shareholders when profits are rising
• Risks to shareholders when profits are falling

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Advantages of ratios
• Comparisons are relative to other figures
• Compare businesses of different size
• Gives picture of company strategy
• Financial and trading performance
• Compare with industry averages
• Simple summary of complex information

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Reasons for using ratios
• Gives summary statistics
• Helps identify industry benchmarks
• Input to formal decision model
• Standardise for size

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Applications of analysis
• Predictions of corporate earnings
• Construct projected financial statements
• Predict corporate failure
• Indicators of financial distress
e.g. Altman’s models, combination of ratios

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Problems with ratio analysis
• No agreement on definitions or specific set of
ratios
• Accounting estimation
• Data not available
• Timing of data does not match
• Differing accounting policies
• Negative numbers and small divisors
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Limitations of ratio analysis
• Diverts attention from the underlying information
• May not give sufficient attention to the notes to
the accounts
• Accounting policies may affect comparison
• Industry differences

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Creative accounting
Could involve:
• Inflating reported profits and EPS
• Accounting for losses via balance sheet reserves
and all profits through P & L
• Reporting profits without generating equivalent
cash
• Reporting lower borrowings

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Survival Tips for Accounting Jungle
• Read the accounts backwards
• Read the accounting policies and compare
• Screen accounts using filters – e.g. high profit
low tax, changing depreciation policies
• Cash is King (or Queen)
• Assess risk: If in doubt, keep out (or get out)

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Return on Capital Employed
Profit before interest and taxation x 100
Shareholders’ funds plus long term debt

• Often called ‘Operating profit’


Assets minus Liabilities = Equity
• Total assets minus current liabilities equals
Shareholders’ funds plus long term loans
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Return on Capital Employed
Top line questions
• What increases/ decreases profit?
• Sales? Operating Costs?
Bottom line questions
• Recent increases in assets may not yet have
created profit
• Is there any debt ‘off balance sheet’?
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Return on Shareholders Funds
(also called Return on Equity)
Net profit after taxes x 100
Shareholders’ funds

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Return on Shareholders Funds
Top line questions
• What increases/ decreases profit?
• Sales? Operating Costs?
• Interest charges? Taxes?
Bottom line questions
• Is the company high/ low geared?

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Net Profit Percentage
Net profit after taxes x 100
Sales
• Often shown as ‘Profit attributable to
ordinary shareholders’
• Sales also called ‘turnover’

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Net Profit Percentage
Top line questions
• Is gross profit high or low?
• What are the admin and selling costs?
• What are the effects of interest and taxation?
Bottom line questions
• Is the measurement of sales explained?

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Gross Profit Percentage
Gross profit x 100
Sales

Gross profit = Sales minus cost of sales


Cost of sales = making ready for sale

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Gross Profit Percentage
Top line questions
• Have sales volumes or prices changed?
• Have costs of sales changed?
• Are costs of sales mainly variable or fixed?
Bottom line questions
• Is the measurement of sales explained?

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Current Ratio
Current Assets
Current Liabilities

Solvency = Ability to meet obligations as


they fall due
Working capital = CA minus CL
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Current Ratio
Top line questions
• What affects levels of stocks, debtors, cash
Bottom line questions
• What affects levels of bank borrowing, trade
creditors, other short term creditors
Overall - How does the company manage its
working capital?
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Quick Ratio (Acid Test)
Current Assets less Stock
Current Liabilities

Solvency = Ability to meet obligations as


they fall due
Cash flow: How does the company manage
inflows and outflows of cash?
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Quick Ratio (Acid Test)
Top line questions
• How is the company managing debtors and cash?

Bottom line questions


• How is the company managing trade creditors and
bank overdraft?

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Stock Holding Period (days)
Stock x 365
Cost of Sales
• Change 365 to 12 for a calculation in months.
• Sales minus cost of sales equals gross profit

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Stock Holding Period (days)
Top line questions
• Year-end stock or average stock? Use year-end
for ease of calculation but check there are no
significant changes from start.
Bottom line questions
• May have to make some approximations to get
cost of sales

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Debtor Payment Period (days)
Trade Debtors x 365
Sales
• Debtors = Accounts receivable (customers
who buy on credit terms)
•Use notes to the accounts to find trade
debtors.

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Debtor Payment Period (days)
Top line questions
• Average or year-end? Year-end is less
trouble but check there are no major
changes.
Bottom line questions
• Are all sales made for credit? Think about the
nature of the business.
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Creditor Payment Period (days)
Trade Creditors x 365
Purchases or cost of sales
•Trade creditors = Accounts payable
(suppliers who provide goods on credit terms)
• Use notes to the accounts for detail.

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Creditor Payment Period (days)
Top line questions
• Average or year-end?
Bottom line questions
• Opening stock + purchases - closing stock = Cost
of goods sold.
• Should be Purchases but Cost of goods sold is Ok
if stocks are constant.
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Gearing
Long Term Debt
Long Term Debt plus Equity
• Look carefully at balance sheet and use
notes to accounts.
•Add Preference shares to Debt
•Omit Provisions

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Gearing
Top line question
• What are the sources of finance that create fixed
commitments to pay interest and repay capital?
Bottom line question
• What is the total long-term financing of the
business, based on borrowings and equity?

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Interest Cover
Profit before interest and tax
Interest expense

• EBIT = Earnings Before Interest and Taxation


• Interest expense: either in profit and loss account
or in detailed notes.

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Interest Cover
Top line questions
• What is the amount of profit available to ‘cover’
interest payments?
• Is the company generating sufficient wealth to
meet interest payments?
Bottom line questions
• What is the cost of servicing borrowings?

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Concepts, Cost and Costing

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Management accounting
• Integral part of management
• identify, present and interpret information
• for strategy, planning and control,
• for decision taking and use of resources
• for disclosure to employees
• to safeguard assets

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Management accounting (contd)
• Internal use within organisation
• No regulation by law
• Projections for future
• Analysis of past
• Directing attention, planning and control
• Solving problems

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Measuring and
analysing
performance
Implementing Examining future
plans environment
Action plans and budgets
Developing
objectives
Operating plans

Formulating strategy
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Importance of costing
• Many organisational decisions rely on costings
• Costing is complex but essential
• “An accountant knows the cost of everything but
the value of nothing” Oscar Wilde

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Describing costs
• Direct (identified with a saleable unit)
• Indirect (spread across saleable units)

• Indirect costs = Overheads


• How to find a fair way of spreading the
overheads?

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Confusing terminology
• Allocate = give all cost to one unit or centre
• Apportion = share across units or centres
• Absorb (Absorption) Soak up into the units of
output
See page 142 of text book

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Terminology (contd)
• What are the direct costs? Allocate these to units
of output
• What are the indirect costs? Allocate to cost
centres if we know where they belong.
• Otherwise Apportion (share) across cost centres.
• Absorb costs from production centres into
products.

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Absorption bases
Absorb as
• cost per unit
• cost per labour hour
• cost per £ of labour
• cost per kilo of material
• cost per machine hour
Different bases give different answers
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Cost behaviour
Pairs of classifications
• Direct or indirect?
• Fixed or variable?
• Period or product?

Case: Bus company sends buses to 10 schools for


taking children home each day. How does the
company describe the costs?
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Direct or indirect?
Direct for each school:
Driver’s working time, fuel for bus, bridge tolls
Indirect to spread across all journeys:
Insurance, repairs, maintenance, licences,
depreciation, driver’s idle time, holiday pay

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Fixed or variable?
Variable change with activity level
Fuel, repairs, bridge tolls

Fixed regardless of activity level


Drivers’ wages, Insurance, Licences,
Maintenance checks, Depreciation

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Period or product?
What is the product?
A person-mile.
Product costs
Driver’s time, fuel, bridge tolls
Period costs
Insurance, Licences, routine maintenance,
depreciation
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Examples of decisions
• Price setting, tendering for contracts
• Product profitability analysis
• Product design modifications
• R & D management
• Value Engineering
• General Cost Management
• Contracting out / Buying in
• Plant / Department Closure

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Short-term decisions
In the short term business can continue if the selling
price covers variable costs and makes a
contribution to fixed costs.

Contribution = Selling price - variable cost

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Contribution analysis
Break even point =
Fixed costs
Contribution per unit
Pay £1,000 rent for market stall. Buy toys for £6
each, sell for £8 each. What is breakeven
volume?
£1,000/£2 = 500 toys
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Contribution analysis (contd)
Sell 500 at £8 = £4,000.
Variable cost 500 x £6 = £3,000
Add fixed costs £1,000
Neither profit nor loss
How many toys to sell for profit of £4,000?
£(1,000 + 4,000)/£2 = 2,500 toys

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Scarce resources
Sell gardening services and house cleaning.
Contribution per job £10 and £8.
Gardening needs 2 hours per job, House cleaning
needs 1 hour per job.
Shortage of labour. Which has priority?
House cleaning £8 per hour, Gardening £4 per hour.
Contribution per unit of limiting factor

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Short term decisions
• Make internally or buy externally
• Hire own staff or pay agency for outsourcing
• Keep a business activity going
• Take on a special order at lower price

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Other factors in decisions
Not just an accounting matter. Consider
• organisation’s objectives
• relationship with employees
• marketing
• corporate goodwill/ image
• customer reactions
• government policies
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Get the costs wrong and...
•Set prices too high - lose sales;
too low - sell products at loss
•Lose potentially profitable contracts, win loss
making contracts
•Don’t know where we are making / losing money
•Continue with loss making products, cut profit
making products, sub-optimal product mix

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Get the costs wrong and...
•R & D to create ‘better’ product when none
needed
•Product Design Modifications not done when
needed
•Contracting out production that costs more than
internal production
•Making products that could be cheaper to buy in
•Close profit-making Plant / Keep open loss
making plant
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Different Costs for Different
Purposes
Not a single, universal ‘true’ cost.
Appropriate cost is governed by:
Needs of management
Specific organisational situations
Specific problem to be solved
Available information - pragmatics

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Different Costs for Different Purposes
Activity Based Failure Cost Planned Cost
Cost
Average Cost Full Cost Product Cost
Avoidable Cost Historic Cost Quality Cost
Budgeted Cost Incremental Relevant Cost
Cost
Controllable Indirect Cost Step Cost
Cost
Current Cost Joint Cost Sunk Cost
Direct Cost Marginal Cost Standard Cost
Environmental Opportunity Total Cost
Cost Cost
Engineered Overhead Transfer Cost
Cost Cost
Fixed Cost Period Cost Variable Cost
MBA INTENSIVE SEMINARS 2004 Page 92
Costing Problem
•In contemporary organisations the fixed/variable
classification is not relevant
•Logical impossibility of attributing all costs to
products
•Wrong approach to the problem
•‘Solution’ based in the ‘accounting world’ not the
‘organisational world’

MBA INTENSIVE SEMINARS 2004 Page 93


Activity ‘Solution’
Costs don’t drive activities, activities cause costs
Organisations do things that consume resources
and (should) create value
Costing should start with what the firm does -
activities in organisational world

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Activity Based Costing
• What are the activities of the organisation?
• What resources are used by each activity?
• How much does each resource cost?
• Collect cost in ‘cost pools’
• How does each product or service make use of
each activity?
• Share cost from the cost pools.
MBA INTENSIVE SEMINARS 2004 Page 95
Money
cost

Resources

consume
Non-financial
Collect
Data
Activities Performance
Analysis
produce
Outputs

creates Value
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Benefits of ABC
• Makes visible the activities that drive the costs
• Prevents misallocation of costs
• Links costs more closely to responsibility for
causing costs
BUT does not save money or generate profit. It
only gives more accurate information

MBA INTENSIVE SEMINARS 2004 Page 97


Activity costing is...

•Not based on accounting coding structures


•Not based on accounting time frames
•Not based on techniques designed to make
the accountants life easier
•Not based on producing Financial
Statements

MBA INTENSIVE SEMINARS 2004 Page 98


Short term planning

Budgets and
Budgetary Control

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What is a budget?
• Quantified format
• management plans and strategies
• for decision making
• communication medium

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Mission/ goals

Financial plans
Corporate objectives

Assumptions
Assessed market Long term on critical
opportunities/ strategy factors
organisational
capability
Long term plans
MBA INTENSIVE SEMINARS 2004 Page 101
Long term strategy

Long term planning


Market
opportunities Forecasting
assumptions
Short term strategy
Organisational
capability Budget/ short term
Modify
planning
assumptions

MBA INTENSIVE SEMINARS 2004 Page 102


Budget process
• Formalises planning and control
• Defines goals
• Goal congruence - brings goals together
• Authority and responsibility are clear
• Framework to judge performance

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operating financial
Master budget
Sales budget Capital budget
+
Cost of goods sold budget
+ Cash budget
Development /design budget
+
Marketing budget
+ Budgeted
Distribution budget
+ balance sheet
Administration budget
Budgeted profit and loss Budgeted statement
account of cash flow
MBA INTENSIVE SEMINARS 2004 Page 104
Budget preparation
•Start with sales budget (demand driven)
•Then match with cost of sales
•Is this a production organisation?
Plan:
inventories of raw materials, finished goods
purchases to cover sales and inventories

MBA INTENSIVE SEMINARS 2004 Page 105


Budget preparation (contd)
• Is this a service organisation?
Plan service programme, labour needs, materials
needed
• Plan all other operating expenses
• Plan capital expenditure
• Bring together in cash budget, budgeted profit
and loss account, balance sheet.
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Cash budget
• Most important part of budget cycle
• Monthly, quarterly?
• Cash receipts from operations
• Cash payments for operations
• Other cash receipts (new finance, sale of fixed
assets)
• Other cash payments (tax, dividends, interest)

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Fixed and flexible budgets
• Fixed means that budget is not adjusted later if
volumes start to vary
• Flexible budgets means that budget is adjusted to
take account of change in volumes of activity
over the period

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Fixed and flexible (contd)
Budget variable costs of £200,000 for 5,000 units of
output

Actual variable costs are £195,000 for 4,500 units


of output

How has manager performed against budget?


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Fixed and flexible (contd)
Appears to have saved £5,000
But budgeted cost = £4 per unit
So flexible budget for 4,500 is £180,000
Performance is £15,000 worse than flexible budget.

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Alternative approaches
Easy approach = Last year plus inflation

Zero-based budgeting
• Start with a clean sheet
• Justify every item
• Focus on goals and objectives

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Alternative approaches (contd)
Activity based budgeting
• Extension of activity based costing
• Focus on cost of each activity

Kaizen budgeting
• continuous improvement
• budget is achieved if improvements are met
MBA INTENSIVE SEMINARS 2004 Page 112
Not-for-profit organisations
• Goals and objectives measured differently
• Need to be cost effective

Planning programming budget system


• Focus on outputs rather than inputs
• ‘joined-up’ government

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Behavioural aspects
Budgets can motivate employees to achieve goals of
the organisation. What helps?
• degree of difficulty
• top management participation
• perceived fairness
• feeling of ownership
• avoid discontent about preparation
MBA INTENSIVE SEMINARS 2004 Page 114
Not foolproof
Why might budgets fail?
• Fail to understand changing environment
• using unsuitable existing structures
• fail to understand business systems
• lack of senior management support
• fail to understand central role of budgeting

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Are budgets necessary?
What matters is PLANNING
This does not have to use budgets. Essential:
• Set targets: to maximise long term value
• Strategy: Make development continous
• Growth and improvement: challenge staff
• Resource management: wealth creation

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Are budgets necessary?
• Co-ordination: manage cause and effect
• Cost management: challenge all costs
• Forecasting: use rolling forecasts
• Measurement and control: key indicators
• Rewards: unit rewards not individuals
• Delegation: give managers freedom to act

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Performance Measurement

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Strategic planning
Five year plan, rolling forward.
• Profitability
• Growth of sales, profit
• Market share
• Customer satisfaction
• Rate of innovation
How to measure achievement of strategy?
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Accounting-based performance
measures
Profit?
• Could compare actual profit against budget, but
companies don’t give information
• An absolute measure, needs ratios for
comparison.
• Affected by choice of accounting policies
• Measured differently in different countries

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Accounting-based performance
measures (contd)
Profitability
• A relative measure, better for comparison.
• Calculate for subdivisions of an organisation.
Methods
• Return on capital employed
• Residual income
• Economic value added
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Return on capital employed
Profit before interest and taxes
Fixed assets plus current assets less current
liabilities

Can be used for divisions of a company if assets and


liabilities can be allocated.

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Return on shareholders’ funds
Net profit after interest and taxation
Shareholders’ funds

Can only be calculated for the company as a whole,


not subdivided for divisions of organisation.

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Residual income
Ask: What is the income (profit) remaining after
deducting a notional interest charge for the use of
capital?
X Z £000’s
Operating profit (EBIT) 18 1,500
Capital employed 100 10,000
ROCE 18% 15%
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Residual income (contd)
Suppose cost of capital is 10% for both.
X Z £000’s
Operating profit (EBIT) 18 1,500
Less interest charge (10) (1,000)
Residual income 8 500

Company Z gives higher income to shareholders

MBA INTENSIVE SEMINARS 2004 Page 125


Economic Value Added (EVA)
Companies should deliver value that exceeds the
cost of capital.
X Z
Profit after tax (before interest) 13 1,050
Interest charge (net of tax) (7) (700)
EVA 6 350
Z gives higher EVA than does X
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Performance of a division
Divisions are created by decentralisation
• Gives greater responsiveness
• Allows faster decisions
• Motivates managers
• Uses specialist experience of managers
But needs a measure of performance

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Performance of a division (contd)
Problems of decentralisation
• Focus on division, not on total organisation
(Called ‘dysfunctional decision making)
• More information is needed, cost involved
• Duplication of activities

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Performance of a division (contd)
Cost centre
• Manager is responsible for costs
Discretionary cost centre
• Manager has some choices in cost budget
Revenue centre
• Manager is responsible for generating planned
sales
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Performance of a division (contd)
Profit centre
• Manager is responsible for revenues and costs
• Target profit is set
Investment centre
• Manager is responsible for resources and profit,
target return to be achieved

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Transfer pricing
What price is charged for transfers between
divisions within an organisation?
• Variable cost?
• Variable cost plus a profit margin?
• Variable cost plus portion of fixed cost?
• Variable + fixed + profit margin?
• Negotiated price? Reflect market?
MBA INTENSIVE SEMINARS 2004 Page 131
Financial Performance
Measurement
• Success / Failure often determined by accounting
numbers
• Growth in profit, ROCE, Sales
• Reduction in costs, headcount, errors, stock
• Financial Ratio Analysis

MBA INTENSIVE SEMINARS 2004 Page 132


Financial Performance Measurement
(contd)
• Achieving outcome at or under budget
• Adverse / Favourable variance analysis
• Project NPV – cost overruns
• OBJECTIVE APPROACH TO Performance
measurement

MBA INTENSIVE SEMINARS 2004 Page 133


Problem with financial measures
A Simple Scenario.
Division in large company enjoyed major growth in
profitability over two years ..manager promoted.

New manager ….drop in profits.

WHY ?
MBA INTENSIVE SEMINARS 2004 Page 134
Financial measures (contd)
Top line answer
• Division’s market share dropped
• Costs were reduced by reducing maintenance of cutting
machine, reducing staff training
•build up of stocks (inventory) of unsold goods
Bottom line answer
• Reduced investment in new technology
Financial System did not pick up the BAD Events

MBA INTENSIVE SEMINARS 2004 Page 135


Problems with financial information
• Complexity /mystery and the method of
calculation
• Arbitrary treatment of some cost items
• Time lag between event and the financial ledger
• No direct observable relationship between
activities and reported costs
• Irrelevant to managers
MBA INTENSIVE SEMINARS 2004 Page 136
Problems with financial information
(contd)
• Managers need to convert data into meaningful
information.
• Implied assumption that control costs will control
activities.
• Focus on cost minimisation, not on effectiveness or value-
adding. Could be valid reasons for costs increasing.
• Simplification of organisational activities, by reducing
everything into a single £ value.

MBA INTENSIVE SEMINARS 2004 Page 137


Value of Financial Performance
Measurement
• Managers accept importance of financial outcome
of their function (especially if linked to pay /
prospects).
• Managers will try to increase their profitability.
• Managers often devise their own budget
'systems’.

MBA INTENSIVE SEMINARS 2004 Page 138


Value of Financial Performance
Measurement (contd)
• Need information on relationships between
activities they control and financial outcome
• Ignore formal budget reports / spend time and
effort proving official budget is wrong
• Do not assume that managers can "translate" £s
into actual activities

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Information Managers Use

US study concluded information used for daily


operating control did not come from the budgeting
system.
Managers' information needs are affected by:
•the resources most significant to their process, in
terms of cost, quality, availability
•the time frame in which this information is needed

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Indicators for managers
 level of finished goods
 level of orders (demand)
 key production limiting factors
 simple counts of output per hour / shift / day,
 physical quantities of materials / labour used,
 down-time

MBA INTENSIVE SEMINARS 2004 Page 141


Indicators for managers (contd)
 scrap quantities,
 rework rates.
 capacity utilisation
 physical production requirements (long - medium
and short-term)

MBA INTENSIVE SEMINARS 2004 Page 142


Non-Financial Measures
Non-financial is any information not valued in £s.
It has the following advantages:
• Expressed in terms/language understandable to
managers (non-accountants)
• Requires very little "translation" by managers

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Non-Financial Measures (contd)
• Potentially quicker, relevant
• Relates to events, activities, actual observable
performance
• Can be used to make sense of financial budgets
• Better reflects the "reality" of the situation, not
confused by strange accounting
rules/conventions

MBA INTENSIVE SEMINARS 2004 Page 144


Integrating Non-£ and £ measures
• Activity Based Accounting
• Benchmarking
• Performance Scoring
• Balanced Scorecard
• Strategic Management Accounting
• Many other – multiple criterion decision making,
data envelopment analysis, etc…
MBA INTENSIVE SEMINARS 2004 Page 145
Balanced Scorecard

Financial
Perspective

Internal Business
Customer Vision and Perspective
Perspective Strategy

Learning & Growth


Perspective

MBA INTENSIVE SEMINARS 2004 Page 146


Balanced Scorecard
• systematic attempt to design performance
measurement system that integrates
– organisational objectives,
– co-ordination of individual decision making
– need for organisational learning.
• create an environment that facilitates continual
improvement

MBA INTENSIVE SEMINARS 2004 Page 147


Balanced Scorecard (contd)
• reflect the organisation’s understanding of the
causes of successful performance.
• monitoring performance and what managers
believe are drivers of good performance
• performance measure system should measure the
most critical aspects of organisational
performance.

MBA INTENSIVE SEMINARS 2004 Page 148


Balanced Scorecard (contd)
BS performance measures should

• be clearly understood by all employees


• link manufacturing performance and financial
performance
• be linked to ensure constancy of purpose.

MBA INTENSIVE SEMINARS 2004 Page 149


Balanced Scorecard (contd)
BS performance measures should
• be able to identify cause-effect relations to enable
employees to deal with poor performance and
continue good practices.
• be based on critical success factors
• identify trends and rate of change

MBA INTENSIVE SEMINARS 2004 Page 150


Not-for-profit organisations
• Economy
Cost at which resources are acquired
• Efficiency
Compare inputs and outputs
• Effectiveness
How resources are used
Value for Money
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